The Forgotten Side of Risk Management

The Forgotten Side of Risk Management

Yesterday I flew from Orange County to New York.  Well, that’s not entirely accurate — Actually, the jet was doing the flying and I was just sitting inside and thinking about risk management.

I was pondering the challenge of risk management because I have seen a large number of members commenting that they were very, very cash heavy.  Some are completely sidelined, with 100% of their account in cash.  Others are 90%, 80%, etc., in cash.  Why?  Because of a lack of clarity and an uncertainty about the direction of the market.  “If I buy now…what happens if that Hindenberg Omen thing proves to be correct?”  “All the stuff I want to buy keeps going higher and higher without me.  I keep waiting for a pullback so that I can buy near support…but the stock just keeps advancing to a point where there is no clear support.  Rather, it’s just moving higher.  I don’t want to be the last one to buy, so I’ll just sit here in cash and wait…and wait…and wait…and then I’ll wait some more.”

Does this sound like you?  If so, then listen up and take some notes because I am talking directly to YOU!

Let’s do some easy math.

If you are 0% invested, you’re not going to suffer any losses; nor are you going to make any money.  You are a spectator rooting for a disaster so you can then get on the field.  Good luck with that.

If you are 10% invested, here is your risk profile.  Let’s say you really are asleep at the wheel and your positions sustain a 20% decline in value.  (Note: This should never happen.  Define your acceptable percentage loss before you buy.  William O’Neil recommends 8%.  I have no problem with that.  If you’ve got a different definition for the risk you’re willing to take, that’s fine.  Just define your loss!

So what happens to your portfolio if your positions get nailed by 20%?  Well, your portfolio drops…um,…2%.  You do the math.  10% of $100 is $10.  If you lose 20% of your $10, that’s two bucks!  (I know this is easy math, but me and my right-brained compadres tend to struggle with math).

So you’ve lost 2% of your portfolio by sitting through a 20% disaster in your positions.  Does that put you out of the game?  No!  It serves as a lesson to you that you have a LONG way to go in managing your trading decisions.

Now, what happens if your stocks (10% of your portfolio) all double.  That’s right — they all double in price.  Well, you do the math this time.  Your portfolio gains by…um…10%.  So you have hit a grand slam on every single stock and you haven’t really even run to first base.  You were as right as right could be on your stock selection, but you completely missed the boat on risk management.

Now, I could give a few other examples, but I’m sure you get the idea.  This is an exercise that you MUST do if you want to make the transition from a struggling trader to a thoughtful and competent risk manager.  You must do the work.  I can’t do it for you. 

Apply that generic 10% analysis to your own portfolio.  Where are you in your risk management?

Here’s the thing.  You are probably defining “discipline” as “waiting for the picture perfect entry.”  Well, that’s a pipe dream.  It rarely happens; and when it does, you’re probably so frazzled that you can’t pull the trigger anyway.  Gang, that’s trading.  We may not like it, but we’ve got to accept it. 

If you are not positioned for the upside, then you are not managing risk at all.  You are merely recognizing one side of risk: The possibility that you might sustain a loss.  Again, that’s not risk “management”.  That’s risk recognition, which is easy…and obvious.  Don’t ignore the risk of missing out on profits.  That’s why we do what we do.  Don’t trade to avoid losing money.  Trade to make money.  And to make money, you’ve got to put your money on the table.

You’ve got to diversify.  But diversification goes beyond investing across different sectors and stocks.  Diversification includes position SIZE and TIMING (i.e., not taking 100% of your desired position at one time and at one price).  Since most stocks are in sync with the market (there is an 81% correlation between stocks in the S&P 500 and the S&P itself), piling in at one time puts your positions at risk if the market corrects.  If you buy at what then turns out to be a market peak, you will wind up selling everything at the same time (when the market bottoms out) and be back in cash with some fresh losses.  You will then be licking your wounds and wondering what went wrong rather than having plenty of cash to take advantage of the pullback.

This is what happens when you fail to diversify your size and timing.  But again, do the math.  Let’s say you got 30% invested in stocks and the market then corrects by 10%, taking your stocks down an equal percentage.  You just piled in with 30% of your portfolio and bought right at the top of the market.  What’s your loss?  3%.  If you happened to buy the RIGHT stocks, then you probably haven’t even been hurt that much, because the strongest stocks tend to do “less bad” during market corrections.

And since you’ve only taken a minimal drawdown, you can then be an opportunist rather than a victim of the pullback.

Think like a risk manager, not Bambi standing in the middle of the road on a dark night.  You’ll find that you are trading like an opportunist rather than a hapless victim.

Position yourself to win.  Positioning your self to win is different than positioning yourself not to lose.

For goodness sake, STAY INVOLVED!