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Managing Risk With Less Prediction and More Discipline

Stocks in this article: SPY

NEW YORK (FMD Capital Management) -- This week investors received their first taste of real volatility since the mild June 2013 shakeup in the markets. Being that we have gone well over six months without a serious hiccup in stocks, it's certainly a jolt to the senses when the SPDR S&P 500 ETF (SPY) drops 2.59% in one week. It's easy to forget that we were accustomed to that kind of percentage gyration on an almost daily basis back in 2008.

From a psychological perspective, investors tend to get complacent when a string of consecutive weekly and monthly gains produces a feeling of euphoria. There is a tendency to forget that stocks can go up AND down when the recent bias has been trending higher for a prolonged period of time.

When volatility returns, I have noticed that many investors get jumpy and want to immediately start selling positions to reduce risk. This is likely an emotional reaction to protect gains or guard against further declines in their investments.

It is a natural reaction to believe that this could be the start of a larger correction that could lead to additional downside momentum. Especially considering the length of time that stocks have grinded higher without a significant test of their long-term moving averages. However, you should also consider that the long-term uptrend is still intact and this may just be a minor shake-up in the big picture.

No one knows for certain how this will play out, but there are steps you can take to protect your portfolio.

I am not one to immediately begin dumping my equity allocations in favor of cash or fixed-income as a response to emotional triggers. Instead, I prefer to manage the risk in my portfolio by setting stop losses that allow for moderate price fluctuations and firm exit points. That way I don't have to get too predictive by trying to call a market top and still have the peace of mind that my capital is protected in the event that stocks fall out of bed.

Now the placement of a stop loss is where things get interesting because each investment has its own unique characteristics that need to be accounted for. Typically higher beta positions need move room to move because they tend to have wider price fluctuations. By contrast, lower volatility names might need tighter stop losses due to different risk metrics.

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