How to Control Risk in a Volatile Market

Pay attention to how much risk you're taking on as well as your asset allocation.

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The stock market has provided a wild ride over the past several weeks. Fueled by the debt ceiling crisis in the United States and the subsequent downgrade by Standard & Poor's, as well as issues in Europe, volatility is back with a vengeance.

As investors, we can't control the market environment, but here's how to control risk in your portfolio:

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Manage risk. How much downside risk can you tolerate emotionally, and within the parameters of your financial planning objectives? One way to view risk is to look back at how your portfolio performed during the downturns of 2000-2002, 2008-2009, and over the past several weeks. Were your losses within your expectations compared to your custom benchmarks or the market? How did you fare emotionally during these downturns? Were you tempted to abandon your plan and move everything to cash?

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Control risk with asset allocation. How are your investments spread between stocks, bonds, and cash? How about sub-asset classes and alternatives? Controlling risk is different from eliminating it. A risk-controlled, diversified portfolio should include at least some holdings that have low correlations to each other. As always, you will need to monitor performance to ensure that your portfolio is performing within your expectations in both up and down markets. Note that sometimes in short-term situations even asset classes with historically low correlations move in the same direction as we saw over the past few weeks and during the 2008-2009 downturn.

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Monitor your holdings. Index mutual funds and exchange-traded funds (ETFs) are relatively easy to track. They either have low expenses or they don't, and they are closely tracking their index or they are not. Actively-managed funds and individual stocks or bonds take more work to review. At the outset, have an investment policy in place that includes the criteria you will use to select individual holdings, monitor those holdings, and replace them when needed.

Assuming you are not a trader, but rather a long-term investor working toward various financial goals, you need to have a process in place for your investments. This will help you to control those factors in various market conditions.

Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill. where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Follow Roger on Twitter and LinkedIn. Roger also blogs at Chicago Financial Planner.