Time to talk about risk.
music selection: “New Girl Now” — Honeymoon Suite
weigh-in: 204.2 (3.4)
Corrections of 10% are normal in the market. They happen about once every 735 days. If you are shaken up by this action it points to being unprepared for normal volatility. The first thing and probably the most important is have a proper asset allocation. One hundred percent equity is hotly debated and probably a bad idea for most investors. A case of the nerves during normal volatility events suggests too low an allocation to fixed income. I personally like 60/40 equity/bonds. This produces enough income to cover my annual budget. I will never have to ‘sell at the bottom’. Personally, I like closed end funds for the bond/fixed income allocation and you can see some suggested funds each Friday here at the raptor.
Another strong action you can take to protect yourself from volatility is to follow a strict stop loss policy. Note that you should track your stops offline rather than enter them in the market. The market maker can’t ‘pick you off’ early that way. Stop losses can be set at a fixed price at the time of purchase. I like to use trailing stop losses where you adjust your sell point upward as the price rises. This allows me to lock in some upside and allow my winners to run while protecting me from ruinous losses. Predetermining your pain point at purchase time takes emotion out of the process for you and ensures you act rationally.
It makes a lot of sense to buy primarily stocks that offer a distribution yield. When you buy something that pays no cash, your profits are limited to your ability to sell at price above your cost basis. Since the market can remain irrational longer than you can stay solvent, it offers a lot of relief to collect cash payments. I adjust my trailing stop losses to reflect distribution income. This effectively tightens the stop as time goes on.
The final thing you can do to protect yourself from market volatility is selling options for income. Options income lowers your effective cost basis in equity. You actually have less risk than owning stock outright when you sell an option. This is because the option income is yours to keep no matter what happens to the price of the underlying. I adjust my trailing stop loss to reflect all options premiums collected.
Devour your prey raptors!