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Managing Risk With Less Prediction and More Discipline

Stocks in this article: SPY

There are several different ways that you can determine an initial stop loss point. It may be a straight percentage off the high such as 7% to 10%, or it could be placed using a trend line such as the 200-day moving average. Another alternative is to use points of technical consolidation or breakout on the chart as a line of support that must be held.

Once you have set your initial stop loss, you should actively monitor the price of the investment and the sell point to determine if changes need to be made. Setting a trailing stop loss will allow you the flexibility of having the sell point move higher when the price of the investment moves higher, but still keep a firm floor in place.

Another key component of managing risk is your asset allocation strategy. Investors that are overweight one asset class such as small cap stocks are likely going to experience more anxiety when the tide begins to turn. Especially if they don't have any positions such as cash, fixed-income, options, or inverse plays to offset equity risk.

While bonds were one of the most hated asset classes of 2013, a return of instability in stocks has sent money flying to treasuries and other investment grade bonds as a safe haven trade this year. That is why I prefer to keep a balanced weighting of quality bonds in my portfolio as a method of offsetting risk and smoothing out year-over-year returns. While that may mean I will forgo some additional upside potential in strong equity years, I am happy to trade that opportunity for being able to sleep well at night with a low volatility strategy that produces more consistent results.

The bottom line is that you must evaluate your portfolio and adhere to a game management plan that allows you the potential for positive returns while minimizing downside risk. In addition, setting firm exit points will allow you to avoid large losses in any single investment which could severely hinder your long-term results.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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