Editor's Note: This article is by Guest Author Brett Golden, co-founder and president of ChartLabPro.com
“The essence of investment management,” said legendary investor Benjamin Graham, “is management of risk, not the management of returns.”
It’s valuable advice from a brilliant and successful trader, but how can a “regular” person translate “risk management” into actionable steps that will increase his or her odds for investing success?
Explain and track your trading process. Without a predefined plan or strategy (that you can explain to yourself) you are shooting from the hip and setting yourself up for failure. One of the easiest ways to keep yourself accountable is to maintain a detailed trade journal. In it, record your trades as well as the reasoning, logic or methodology you use to justify entering, increasing, exiting or decreasing a position.
If you’re just chasing flashing dots on a screen and can’t articulate why you want to put money on something, then you probably should pass on the opportunity. In addition, a log of your trading strategy helps when things start to go wrong.
Define your risk: Understand portfolio volatility. Now that you have a system in place to track your trades you need to define what risk you’re willing to take relative to what reward you expect to receive. Even though volatility is not a forward indicator, investors can still make educated investment choices based on a security’s beta which is a measure of a stock’s price volatility in relation to the rest of the market. In other words, how the stock’s price moves relative to the overall market.
Taken a step further, obviously we would like higher beta names in a rising market and lower beta names in a falling market. By reducing higher beta names that are technically breaking down and weak this will help avoid downside volatility. Both upside and downside risk is asymmetric and should be modeled differently. This is the basic concept in letting your winners run and cut your losses early. Understanding and acting on volatility will help you to record your logic for why you are entering or exiting a trade and why you are doing so at that time.
Understand – and do not fight – trends. Just as understanding volatility (beta) is a tool in helping you manage your portfolio and risk, understanding trends is another tool. A stock’s price momentum, for instance, is probably one of its most powerful indicators; it will often move well before the fundamentals -- the “why” behind the price movement -- are revealed. Knowing this you may or may not buy as you see a price moving upward but, conversely, you should never buy as a price decreases in the hopes of securing a “bargain.”
Control your risk by establishing criteria for your position size as well as sector concentration. This is a technique that sophisticated institutional investors use but is easy for anyone to understand. Simply put, many institutional investors will set position limits, typically that no single position will exceed 2.5% of their portfolio. Say you have a $100,000 portfolio and invest $1,000 in a single stock. Once that stock’s value appreciates and is over $2,500 (2.5% of a $100,000 portfolio), it’s time to reduce that position and rebalance. Instead of tracking individual position sizes, of course, some institutional investors check the value of all the positions in a certain sector (for instance, technology) and will sell out of some, but not all positions, once that sector hits a certain percentage of their portfolio.
Don’t fear losses. If your catalyst or theory for buying a particular stock does not pan out, make a note of that in your trading log. Then, immediately move on and look for other opportunities. You can learn from mistakes perhaps even more than successes. But, if you let one loss turn into a fear of all loss then you can become paralyzed by fear of loss itself. That reaction, ironically, becomes an opportunity cost.
Don’t waste time or money trying to work your way out of a bad trade. People make the mistake of thinking they can reduce their “cost basis” by working their way out of a bad trade when in reality they are literally throwing good money after bad. Don’t fear losses, but don’t dwell in them or fight them either. Simply manage your risk and move on.
Brett Golden is President of ChartLabPro, a leading provider of quantitative solutions for retail and institutional investors.
Credits: Brand X Pictures/Antoine Arraou/Getty Images