Risk Management Through Controlling Losses
Develop solid financial market awareness before initiating risk.
I have a tendency to wear my mind on my sleeve
I have a history of losing my shirt
In a separate discussion, we examined managing risk through diversification. Sometimes, market participants seek to control losses in a more 'hands-on' fashion. In this article, we'll look at some ways to actively manage risk.
Defining Risk and Controlling Losses
Stops. Sometimes, market participants use 'stops' to manage risk. For example, a while back Todd Harrison once bought the S&P 500 Index (SPX) for a trade and placed a stop at 1175. A stop is a price level that will cause you to exit your position.
Chart courtesy of StockCharts.com
Why do such a thing? After all, any drop in price might be temporary. But it might not be. So this is about risk management--reducing your potential for loss. Left to their own devices, individuals are usually reluctant to exit losing positions (Odean, 1998). Stops remove emotion from the process and help maintain discipline to cut losses while they're small. For Todd, stops help him stay true to one of his cardinal rules: Never define an investment as a trade that has gone awry.
A separate trade by Todd involving Napster (NAPS) shows how stops are enacted. One morning, NAPS 'gapped higher' on chatter that Google (GOOG) might be interested in acquiring the company (see the intraday chart below).
Chart courtesy of StockCharts.com
The price action and the story caught Todd's attention. After checking the story further and observing the price action for a while, Toddo bought some NAPS in the $4.40 position, and set a stop loss below at about $4.25. A stop is a price level that, if realized, causes you to exit a position. Late in the morning, newswires reported that GOOG denied being in talks with NAPS. This news sent the stock price falling. Todd's stop was triggered and he was out with a small loss.
Setting stops can help market participants manage risk and remove emotion.
Think Twice About Adding to a Losing Position
Seasoned veterans know that emotion is the enemy when participating in financial markets--which is one reason why successful investing is so difficult. One mistake that many market participants make is to 'average down' when a position goes against them (Kahneman & Tversky, 1979). When driven by emotion, this process often results in taking excessive risk--instead of cutting losses in a losing situation. Managing a losing position is of the most difficult financial decision making skills to learn, and one that is highly correlated to success (Schwager, 1989).
A noteworthy example of how to manage a losing position occurred when Minyanville professor John Succo's firm initiated a position in Refco, a securities clearing house that made headlines due to allegations of managerial and accounting fraud and the potential of this situation to disrupt markets. After the position moved against him, John resisted the temptation to add to his losing position and, instead, moved on to the next trade.
Suppose you have $100,000 to invest. You're considering two possible ways to allocate these funds. Possibility I consists of splitting your capital into two $50,000 portions. One of these portions would be invested in the stock of a risky, although potential profitable start-up venture involved in developing alternative energy sources. Possibility II consists of splitting your capital into fifty $2000 portions, with one of these portions allocated to the risky alternative energy venture.
Let's suppose that the worst case scenario happens to the alternative energy company. The venture goes bust and the stock's value goes to zero. How would this affect your portfolio?
Table 1: Comparison of Losses Assuming $100,000 Initial Investment Portfolio
|Asset allocation in portfolio||
Two $50,000 portions
Fifty $2,000 portions
|Allotment to start-up venture||
|Porfolio value if start-up fails||
|% original investment lost||
As shown in Table 1, the impact of a bad investment on Possibility I is considerable. Fifty percent of the original $100,000 investment is lost. The impact on Possibility II is much less severe, as only 2% of the portfolio's initial value is lost.
The message: smaller bets reduce the risk of losing big on any single position. This brings us full circle to the general notion of diversification (Markowitz, 1952) discussed previously.
Develop Market Awareness
One assumption baked into the above strategies is that you are an informed market participant when initiating risk. Of course, this is not always a good assumption. Indeed, many folks spend more time researching their next refrigerator purchase than they do studying prospective financial assets. Developing solid financial market awareness will make you more capable of dealing with the "How much can I lose?" question that is central to risk management.
Kahneman, D. & Tversky, A. (1979). An analysis of decision under risk. Econometrica, 47: 263-292.
Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7: 77-91.
Odean, T. (1998). Are investors reluctant to realize their losses? Journal of Finance, 53: 1775-1798.
Schwager, J.D. (1989). Market wizards. New York: Harper Collins.
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