Is your investment portfolio more like a roller coaster with no exit strategy, just going round and round and up and down, arriving right back to where it started? Don’t just go along for the ride, use a managed approach to limit downside risk and to capture gains. Incorporating a managed approach to risk with standard portfolio management methodologies will put you in the driver’s seat. Some common portfolio strategies that many of you are familiar with are diversification, buy and hold, stop losses, and the last and least effective strategy that many of you may be using, I like to call management by loss aversion behavior. Using a managed approach to risk within any portfolio strategy is easier with the proper tools.
Managing Risk With A Diversification Strategy
Managing portfolio risk through diversification is usually achieved by investing in a variety of equities that are negatively correlated such as large cap stocks, commodities, emerging markets and global equities. Recently though, it’s becoming more difficult to achieve this type of diversification as correlations aren’t constant and many global markets are becoming more similar to U.S. markets.
Reviewing sector risk is a good way to manage risk when using a diversification strategy. Investors can allocate funds to equities in leading sectors which are experiencing lower risk within the overall economic environment. There are many tools available for measuring sector risk including a free tool called the SmartStops Risk Ratio (SRR)™, useful in identifying the magnitude of risk by sector. For example as of March 26th, 2012, the healthcare sector on SmartStops Risk Ratio (SRR) is showing a 30% risk factor meaning 30% of equities in this sector are in an above normal risk state. If we further research using this tool, we find that the telecommunications sector has a 64% risk factor, meaning 64% of equities in this sector are experiencing above normal risk. In this scenario, an investor could rotate out of the telecommunication sector and focus on the healthcare sector, selecting individual healthcare stocks that are currently in the normal risk state.
Many investors choose individual stocks with either a growth or value objective in mind. Growth stocks are corporate stories with rising sales and profits and usually dominate their marketplace. For example, if you buy a stock for its growth potential, review the risk possibilities through data and risk charts. Data might include new information regarding large expenses allocated to expansion, often called “return on invested capital”. Return on invested capital measures whether companies can find profitable projects to inject future growth. A value objective focuses on underpriced bargains which investors expect will return to a “normal” state. A risk chart with re-entry trigger points provides valuable information for knowing when to buy an underpriced bargain.
And don’t forget the number of stocks that you should be holding in your portfolio to assist with risk reduction. In today’s markets, it takes even more positions to achieve a lower risk based on diversification alone. According to Rodney Sullivan, editor of The Financial Analysts Journal, “as recent as 1997, whereas it used to take 20 stocks to eliminate most of the likelihood of enduring more risk than the market as a whole, today, it takes 40 stocks to diversify.”
Managing Risk With a Buy and Hold Strategy
Investors have been taught for years that a buy and hold strategy for portfolio management is guaranteed to outpace the market when comparing rates of return. However, the amount of risk a stock is experiencing has no relation to time and holding the stock for an extended period of time does not eliminate the risk associated with that particular stock. To best manage for risk, if you’re using a buy and hold strategy, one must know when a specific stock is experiencing unusual risk and be willing to sell. Putting your hard earned money to work in a stock that has a normal risk state will achieve higher returns in the long run. On a risk chart provided by SmartStops, if you were invested in Netflix, Inc (NFLX) prior to 2011 and had sold at any of the 6 alert signals from Dec. 2010 until Jul 26, 2011, ranging in price from $184.92 to $262.85 per share, you would have saved yourself from a significant loss. Today, the share price is still hovering around the $120 range. Within the buy and hold strategy, without managing for risk, you would have just ridden that roller coaster down and then hopefully back up again.
Managing for NFLX risk, you could have exited the ride at the first risk alert, waited for the ride to bottom out, and then repurchased at the reentry price (triggered at $81.00 on Jan 5, 2012), thereby increasing protection on your NFLX capital and significantly increasing your returns.
Managing Risk With a Stop Loss Strategy
Managing an investment portfolio using a stop loss strategy is effective. The difficulty lies in correctly identifying the optimum exit points. Choose an exit too close and you could be exiting prematurely and an exit choice too far away gives up significant gains before your protective exit triggers. Optimized exits should be tailored to each individual equity, taking into account its daily volatility and current trading pattern. SmartStops publishes updated optimized exits each market day and through its BrokerLink service, maintains stop loss orders with broker partners such as TD Ameritrade and TradeKing. Using an automated risk assessment decision tool that intelligently adjusts each day for the optimal exit and re-entry points manages risk effectively and more profitably.
Managing Risk With Loss Aversion Behavior Strategy
Managing a portfolio using loss aversion behavior is not a very effective strategy but one that many investors utilize. When purchasing a stock, we often become not only financially invested in the equity but also psychologically invested. As a result, we view the act of selling this equity as an admission of guilt of a poor decision. Instead, we often look for information to validate our initial buying decision, even in the face of losses and overwhelming evidence to the contrary.
By trying to find information that confirms the buying decision, investors discount other meaningful information and often hold the loser position hoping for a rebound. Investors could eliminate the loss aversion behavior by taking the emotion out of the investment and relying on analytical tools for direction. SmartStops is one of the few companies offering an automated risk assessment decision tool that notifies investors when a stock is experiencing unusual risk. With the information gained in the risk alert, the investor can then do further research and make a rational, timely decision based on facts and not on emotion.
Whichever investment strategy you choose to use, further manage the risk within your portfolio. Don’t get taken for a ride.