Risk Management: Learning to Fly

In "Manage Risk Like a Pro" I explain how to identify, quantify and control your risk as an investor. Now, to get a keen sense of how to act when you go into risk management mode, I would like to show you how I have managed risk in what (so far in 2008) has been a tumultuous and challenging investment environment.

Investment risk management is a lot like flying an airplane. When cruising at high altitudes there is not much work that you need to do, except make some minor adjustments, monitor the instrumentation and take action during turbulence.

The hardest part of flying is taking off and landing the plane. Managing the risk in your investment portfolio is no different. As long as your positions are cruising along, then managing them is relatively easy. But once you start to get large moves up or precipitous moves down in the market, then you must take action.

For the first five months of the year, the market has been on a volatile trajectory -- both up and down -- as you can see from this chart below of the S&P 500:

Click here for larger image.

The Take-Off

I have highlighted a few points on the chart. First, are points A and B.

At these points the S&P 500 was off nearly 19% from its October 2007 highs and about 13% from the end of 2007. At points A and B, the financial and non-financial media outlets were all talking about market crashes and bear markets. The financial system was under a great deal of stress. Technical analysts and bearish investors were firmly in control of the markets and many investors' emotions.

At points A and B, the temptation was to simply throw in the towel.