Risk Management

After more than 28 years of investing personally and professionally, I am of the opinion that risk management is single handed the most important component of the investment process. Most investors learn about market risk the hard way – they lose money. If we take the time to learn how to manage risk relative to each position in our portfolio we will be far ahead of the game.

What is risk management? It is the process of managing the risk of money in relationship to the market. Simply put – it is money management. When money management is discussed risk is one of the many elements addressed. From my perspective it is the embodiment of money management, the foundation on which you build a portfolio of stock, bonds and other investments and the process by which it is managed until the asset is sold. Taking on too much risk by position or portfolio is the downfall of many investors.

In Step Two we discussed learning before you invest. This is a case and point of learning about risk relative to the investment you select as well as the strategy you implement. How do we learn to manage risk? To borrow again from Rule Two – KISS! Keep it simple. Start simple so you can learn the variations of risk and then devise a strategy to protect your principle invested.

For the sake of simplicity let’s return to the index ETFs (Exchange Traded Funds). For this example we will use SPY, SPDRs S&P 500 Index ETF. This fund corresponds to the index and in fact is invested in all the stocks in the index. The fund trades intraday like a stock under the symbol SPY. Thus, your risk of owning SPY is equivalent to owning the index itself. If you put money to work in this fund how would you manage the risk? STOPS.

It is amazing how many investors do not use stops to protect against the downside risk of the market. As many of you are aware, a stop is nothing more than a standing order to sell, in this case SPY, if it falls below a specific price. Why would you want to have this order in place? Take a moment and think about what emotions you go through when the stock market is declining in value. Anxiety? Fear? Panic? They may all over time describe the feeling you experience during a correction. Thus, the reason for using stops; taking emotions out of the equation or decision process.

Two things come to mind relative to losing money. First, disgust and depression as no one likes to lose money. Second, psychological brain damage as many will dwell on the loss. Here in lies the challenge for most investors; getting over the damage done from losing money. This is where having a defined strategy for managing the process of investing is important. Part of that strategy is a defined stop on every position within your portfolio. The stop is determined at the point of purchase based on the strategy first and on the amount of money you are willing to risk second. Thus, a stop allows you to take the unknown and make it known. Defining your loss prior to starting will give you clarity and focus to each position and remove some or all of the emotions at the defined exit point.

We have heard the saying, ‘let your profits run and cut your losses’.  Stops put in place are a method or strategy to allow you to let your profits run as you ladder your stop up as the price rises. In the same way it cuts the losses on your losers and keeps you from holding them too long on the way down. Stops are a great risk management tool and one well worth time to learn how to use. The chart below is an example of how to manage your stops on a position letting the profit run until which time the stop is hit. Invest the time to learn how to use stops and truly learn to manage your money!