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.
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.