The risk of a total investment portfolio is always less than the sum of the risks of its individual parts. Many investors are unable to find sight of that fact when making investment decisions. When adding up an additional security to your portfolio, you may look at the risk of the additional security only, not at its ability to reduce risk overall.
Shorting a stock is always well thought-out a risky strategy. You can, at most excellent, make a 100% return on the position if the stock declines to zero. In speculation, the losses are infinite if the stock continues to rise. For instance if you shorted a $10 stock and it climbed to $50 you would lose five times your original investment you have made.
In the same way, buying a leveraged inverse ETF is also risky. For illustration, the ProShares UltraShort S&P 500 ETF aims to provide performance, which is the contrary of, and double that of the Standard & Poor's 500 Index (S&P 500). Consequently if the S&P 500 rises by 1%, the leveraged inverse ETF should drop by 2%; and if the S&P 500 falls by 1%, the inverse ETF should rise by 2%.
The above approaches would be considered risky, but if prepared properly in a portfolio context, you can decrease your risk instead of increasing it. For instance, if you hold a large position in a stock that you cannot sell, by shorting the same stock in an equivalent amount, you have effectively sold the position and reduced your risk of the stock to zero. In the same way an investor with a portfolio of U.S. stocks can decrease their risk by buying the appropriate leveraged inverse ETF. A 100% hedge will protect you from risk, but it will also effectively reduce your exposure to any upside.
A put option is a risky investment that gives you the precise way to sell a stock or an index, at a predetermined price, by a specified time. Buying a put option is a bearish approach since you believe the stock or the market will go down. You make money on a decline, and the most you can lose is the price you remunerated for the option. Specified the leverage of an option, it would be well thought-out a risky investment. On the other hand, when a put option is paired with a stock that you currently own, it provides security against a lower stock price. Nothing like hedging, which limits your upside, buying a put would still present you with unlimited upside. It is, in outcome, like buying insurance on your stock, and the cost of your put option is the insurance premium
A portfolio consisting typically of bank stocks and utilities are considered relatively safe, while gold and gold stocks are by and large considered risky. On the other hand, buying gold stock rather than another financial stock may in fact lower the risk of the portfolio as a whole. Gold and gold stocks characteristically have a low correlation with interest-sensitive stocks and, at times, the correlation is even negative. Buying riskier assets with a low correlation with each other is the traditional diversification strategy.
Which is well thought-out the riskier portfolio? It is the one that contains 100% U.S. Treasury bills (T-bills) or one that has 80% equity and 20% bonds? In complete terms, T-bills are the definition of risk-free investment. Nevertheless, an investor might have a long-term asset mix of 60% equity and 40% bonds as their yardstick. In that instance, compared to their yardstick, a portfolio containing 80% equity will have less risk than 100% U.S. Treasury bills. For the investor who has all cash, they can decrease their risk relative to their long-term yardstick by purchasing the risky equity.
The risk that your investments will not counterpart that of your yardstick is called tracking error or active risk. The greater the difference in performance between the two, the greater will be the active risk or tracking error. One of the eye-catching features of index funds and ETFs is that they are predestined to replicate yardsticks, thus dropping the tracking error to almost zero. Buying an ETF that matches your yardstick is always well thought-out a safer investment than an actively managed mutual fund, from the perspective of yardstick or active risk.
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