These portfolio risk management techniques will help you build a balanced portfolio and increase your long-term gains.

These time-tested portfolio risk management techniques will help you build a well-balanced portfolio and increase your long-term gains.

Here are two key portfolio risk management techniques for individual stocks

If a single stock represents, say, 10% or more of your portfolio, it exposes you to a high degree of risk. You need to take a close look at it and make sure you are willing to accept that degree of risk from a single stock holding.

On the other hand, if a stock makes up less than 1% of your portfolio, you need to recognize that it is taking up just as much of your time as the stock that makes up 5% or more of your portfolio. But even if it’s a winner, you’ll generally make much less profit from it than you can make with a stock that comprises, say, 5% or more of your portfolio. In the end, you’ll need to decide if holding a stock that can have only a small impact on your finances is worth your time.

If you don’t want to buy more of the stock that makes up just 1% or less, you may be better off selling it.

You will improve your chances of making money over long periods, no matter what happens in the market, if you diversify your holdings across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities.

Start by adding up the value of the stocks you hold after separating them out into each of those five main economic sectors. That will give you the relative weighting of each sector in your portfolio.

By weighing the balance among the five sectors, you can also form an idea of the degree of overall risk in your portfolio.

Keep in mind that the Manufacturing and Resources sectors generally expose investors to above-average risk. Stocks in the Utilities sector generally expose you to below-average risk; so do stocks in the Canadian segment of the Finance sector, particularly the top five Canadian banks. (The U.S. finance sector is generally more volatile and risky than its Canadian counterpart.) The Consumer sector falls somewhere in the middle.

Portfolio risk management techniques: Different sectors can play different roles

The best of Consumer-sector stocks can provide some protection against economic downturns. That’s a key difference between Consumer stocks and companies in the Manufacturing & Industry sector or those in the Resource sector. They are far more sensitive to the ups and downs of the economic cycle.

As a general rule, Resource stocks provide the most effective hedge against inflation because they gain directly from the rising prices of the commodities they produce. Utility stocks used to provide a hedge of sorts against recessions, due to their steady earnings and dividends. However, that is less true today because of changing technology and deregulation of the utility sector.

While it pays to be aware of these general tendencies, you should resist the temptation to fine-tune your portfolio according to theories or predictions about inflation and economic downturns. No one has ever consistently predicted either one, neither by timing or degree, so most investors will want to include stocks from most if not all of the five economic sectors in a well-balanced portfolio.

Bonus tip: Invest in blue chip stocks

The best blue chips offer both capital gains growth potential and regular dividend income. The dividend yield is certainly one of the most concrete indicators of a sound investment. It is the percentage you get when you divide the current yearly dividend payment by the share price of the investment. It’s an indicator we pay especially close attention to when we select stocks to recommend in our investment newsletters.

We feel most investors should hold the largest part of their investment portfolios in securities from blue chip companies. Ideally, these stocks should offer good “value”—that is, they should trade at reasonable multiples of earnings, cash flow, book value and so on. Ideally, they should also have above-average growth prospects in expanding markets.

Portfolio risk management techniques vary between investors. What do you do to help yourself sleep at night when you’re worried about the volatility of your portfolio?

An unbalanced portfolio can put you at risk if one economic sector crashes. What do you do to lower the risk in your investment portfolio?