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Strategies for Mitigating Risk

If you can mitigate risk, you may be able to ride through changing market conditions and stay invested long term. Balancing and rebalancing your portfolio is one way to manage risk, as we explained here, but you’ll also want to consider the risk of the stock and bond funds you own, and then look for ways to keep your riskier positions in check.

Here are some of the tactics we use in the Upgrader Funds that you can implement in your own fund portfolio.

What to do about riskier stock funds

Not all stock funds are alike. Sector and country-specific funds, which focus on one segment of the overall markets, are typically more volatile than funds that are diversified across many different sectors and regions. And within diversified funds, some funds are more broadly diversified than others. If you invest in more concentrated funds, you could experience more volatility than an investor who holds only core diversified funds, but you can seek to mitigate this volatility in these three simple ways:

1. Limit Your Exposure

Limit how much of your portfolio is invested in more aggressive stock funds and focus most of your growth portfolio on core diversified funds. This is what we do in most of the growth portfolios that we manage. 

In the Upgrader Fund (FUNDX), for example, we keep the majority of the portfolio (70%) invested in core diversified stock funds. We limit sector fund exposure to about 10% and cap aggressive funds to 20%.

2. Diversify Your Positions

You’ll also want to diversify your exposure to riskier stock funds. This way, if a single sector sells off, it will affect only part of your portfolio. We don’t own just one or two aggressive funds; instead, we invest in a range of different funds that have had strong recent returns. 

As of December 30, 2015, FUNDX’s sector exposure included technology, consumer discretionary, home construction and banking funds.

3. Take Smaller Positions

Taking smaller positions in more concentrated stock funds may help limit the damage if one of these funds suddenly drops. Remember riskier stock funds can fall more than 10% in a matter of weeks. In September 2015, biotech fell 15% in a single week. This is why we typically take 1% to 2% positions in a number of sector funds.

As of December 31, 2015, just 2% of FUNDX’s portfolio is invested in iShares North America Software ETF (IGV), which invests solely in technology stocks, but we have nearly 8% in iShares S&P 500 Growth (IVW), which invests in a mix of stocks that all have strong growth characteristics. (Click here to see FUNDX's holdings.)

Bond funds can be risky, too

You can use these same techniques to mitigate risk in your bond fund portfolio. As a group, bond funds tend to be less volatile than stock funds, but some bond funds are riskier than others. Lower-quality bond funds, like high yields, for example, tend to be more volatile than higherquality intermediate-term bonds.

High-yield bonds were among the best performers for most of the last five years, but they fell in late 2015, and if most of your bond portfolio was in high-yield funds, your portfolio fell, too. If you capped how much you invested in riskier areas of the bond market, however, your portfolio was less affected by the sell-off. This is what we do in the Flexible Income Fund (INCMX), we cap exposure to high-yield bonds, foreign bonds, and strategic bonds. This allows us to use riskier bond funds, which can add tremendous value at times, without dramatically increasing the overall risk of the Fund’s portfolio.

The risk of doing nothing

Your investment strategy should also help you mitigate risk in your fund portfolio by helping you know when it’s time to move on. The Upgrading strategy we use to manage the Upgrader Funds has a clear sell signal that can help us limit losses. When Chinese stock markets sank in summer 2015, for instance, we knew what to do: sell our small position in iShares China Large-Cap ETF and buy into funds with better recent performance. The strategy helps us avoid riding lagging funds all the way down and gives us the chance to buy into new market leaders.

Fund holdings are subject to change at any time and are not recommendations to buy or sell any security. References to other funds should not be interpreted as an offer of these securities.

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