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A three pronged approach to portfolio risk management

No new trades this week.

music selection:  “Welcome To My Life” — Simple Plan

weigh-in:  196.8 (1.2) – back on track.

The best investors obsess about risk.  It is a quirk of mathematics that a 50% decline requires a 100% gain to break even.  So losses can hurt a lot more than gains help out.  Today, I am going to cover the three most important risk management tools for your portfolio.

Asset allocation:  Not enough is written about this topic.  Over long periods of time, it is more important to have the right mix of equity to bonds than it is to pick “good” stocks.  There is a growing chorus in the early retirement movement to go with a 100% stock allocation.  This to me, is foolish.  Without a buffer, sequence of returns risk can end an early retirement.  But there is another park of asset allocation that is equally important and that is diversification.  Most investors have a home country bias and invest too much in their own country and not enough abroad.  Similarly, within America investors gravitate towards local industries with Midwest Americans buying lots of heavy industry and West Coast Americans over allocating to tech names.  Having exposure to many different industries can reduce the volatility in a portfolio.

Position sizing:  Too many people put too much capital in a few high conviction ideas.  This is quite dangerous as the market has a way of humbling the mighty.  It is inadvisable to put more than 5% of your capital into any one ticker.  You can go a little higher with well diversified funds and ETFs.  This does not necessarily mean you must continually rebalance to maintain your position sizing.  There is a lot of research that indicates it is best to let your winners run (and to cut your losers early).  My next point will make clear when to sell.

Trailing stop losses:  The best way to protect yourself from catastrophic losses while allowing access to upside is to implement a strict trailing stop loss rule for your portfolio.  This lets you predetermine what your pain threshold is, thereby taking emotion out of the equation for determining when to sell.  You track the daily closing price of each of your positions watching for new highs.  Each time you notch a new high, you adjust the exit price accordingly.  I usually use a 25% trailing stop loss.  So if a stock rises to a new high of 100 dollars, my stop loss will be set at 75 dollars.  I likewise adjust my stop losses for dividends and other distributions received.  So, if a stock with an all time high of 105 has accumulated 5 dollars in distributions during my holding period, the 25% stop loss will still be 75 and not 78.75.  You can theoretically get to a stop loss of 0 this way.  And that is fine, a company that has paid distributions in excess of your cost basis is probably worth keeping through a crash.

Devour your prey raptors!

{ 3 comments… add one }
  • Mr. Tako August 13, 2018, 6:42 pm

    Interesting post FV! I do almost the exact opposite of what you’re suggesting here and it’s worked out for me. I’m not a usual investor though.

    There are a few things in this post I agree with however: Letting your winners run, and avoiding location/familiarity bias.

    Good luck!

  • DrMike August 14, 2018, 3:17 am

    Very interesting post. I’m just getting started adding options into my mix. Do you factor in covered call income or potential income in your stop loss thinking?

    • The Lizard King August 14, 2018, 6:23 pm

      DrMike,

      I do in fact reduce my stop loss by options premiums earned. I maybe should have noted that in the article. Good eye!

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