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
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
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.
During this period in March, I received several calls from my clients. One wanted to move to cash and one wanted me to buy puts on their portfolio. A and B are maximum points of investor negativity -- pain and panic.
A good professional investor would not be selling everything at points A and B. Instead, they would get ready for a rebound. Here is what I do at these stress levels:
Get rid of mistakes. Identify the losers in your portfolio and sell them. Don't think that everything will come back when the market rebounds. Cleanse out the portfolio. Get rid of what is not working and will not work in the rebound. Over the course of the last twelve months, you should have lightened up on financials and consumer discretionary stocks. This process has both psychological and risk benefits to your portfolio.
Add to strength. Energy, material and handheld device stocks were sold off, but were still fundamentally strong growth stories -- all of which, were relatively unaffected by the financial crisis. Apple in the $120s was a bargain. The same could be said for Devon Energy and Freeport McMoran Copper & Gold . During the recent doom and gloom period, the opportunity was presented to start or add to your positions in strong sectors.
Maintain a little cash. Use that cash to trade around your positions by using exchange-traded funds until a new trend can be established.
On the other end, let's look at points C and D on the chart.
At points C and D, we hit multi-month highs for the major indices. From the market lows of points A and B to highs of C and D, the S&P 500 rallied about 12%. Investors were beginning to overpay for stocks once again. In other words, valuations were getting a bit stretched. That is not to say that euphoria was settling in, but a fair amount of overconfidence was apparent in the marketplace. All of a sudden those technicians who were spouting off about the depths of despair two months earlier were now talking about "breakouts" and the return of "momentum."
And the bears that were so vocal at points A and B were silent.
A good professional investor would not be buying recklessly at C and D. Instead, they would harvest gains and getting read for a pullback. Here is what I do at these elevated levels:
Focus on targets. Stocks that met or exceeded my price targets were immediately sold in part or in whole. For example, I had a $32 price target for Buffalo Wild Wings in 2008 and $38 in 2009. As it blew past $32 I sold half of my positions at nearly $33.
Ease the stress. Stocks that contributed more risk and volatility to the portfolio were sliced down. As much as I love Apple -- I started buying stock in the $30s (a few years ago) and it was close to 15% of my portfolio -- I sold about 25% of my Apple position. The same was done for holdings in various other stocks, such as Research In Motion ( RIMM), BHP Billiton and Freeport McMoRan -- all of which have grown and needed to be pruned back.
Again, get rid of mistakes. Even though the market rallied around points C and D, I still may have some disappointing holdings still on the books. Those get sold because if they can't rally in a strong market, then why should I hold them for a pullback? An example of such a mistake that I sold at the height of the rally was China Medical ( CMED).
Raise cash. I raised nearly 15% in cash. With that cash, I bought some shares of the Ultra Short S&P ETF , which reduced my overall exposure to about 60%. To learn more about this strategy, check out my lessons on hedging techniques and managing risk with ETFs.Sure enough, the following week, the S&P 500 corrected about 3.5%. I sold the SDS and now use the cash for trading ETFs, until I go back to cruising altitude (which I will cover next).
With the hardest two parts of the risk management process out of the way, you can get back to picking stocks. With cash on hand, here is the process that I go through as I get ready for the next flight to take off:
Trade ETFs. I continue to use cash for ETF trading -- both long and short -- until I am fully invested in individual stocks.
Pick strong stocks. I identify stocks that I find attractive, based on my fundamental analysis. Furthermore, I set:
My price entry point, the level at which I would make my initial transaction.
The capital allocation for that investment, normally quantified as a percentage of assets.
My growth assumptions and price targets so I know my eventual exit strategies.
Move cash from ETFs to stocks. As these new investments are acquired, I reduce my cash and capital available for ETF trading. This process is continued until I reach a fully invested cruise control condition.
As always, I will look to risk manage poorly performing stocks or stocks that hit my price targets to raise more cash for other opportunities.
Like flying, the most difficult aspect of investment risk management is during times of extreme action.
To avoid costly mistakes, learn how to "take money off the table" and employ capital in a controlled manner. Above all, if you are an investor, then stay an investor. Don't turn into a "day trader" or technical analyst just because those are the most vocal market participants and their deafening roar is controlling your emotions.
At the time of publication, Rothbort was long AAPL, FCX, BHP, RIMM and BWLD, although positions can change at any time.
Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.
Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.
Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.
For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at
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