Risk management is a critical component to investing in the stock market. In the article “How Risk Management Should Guide Every Stock Trade” we defined risk management as well as looked at some common investing myths that devalue risk management. Today, we’re going to get practical and explore some specific ways investors can develop and apply risk management techniques in order to preserve capital, minimize risk, and maximize returns (the motto here @ Invest in the Markets).
Common Risk Management Techniques
Risk management is not something we’ve created here at Invest in the Markets… it’s commonly discussed in almost all investment circles. Most professional advisors discuss it, all “know your client” surveys include questions about it, and many investors think they are doing it; however, despite it’s popularity, risk management is rarely applied among investors in meaningful ways. But before we consider some practical steps investors can take to manage their investment risks, let’s look at a few common techniques.
Diversification – Perhaps the most popular buzz word among investors is diversification. Basically, this is the concept of reducing risk by investing in a variety of assets. The common proverb “Don’t put all your eggs in one basket” is an example of diversification. A more ancient proverb, found in a book called Ecclesiastes in the Bible reads, “But divide your investments among many places, for you don not know what risks might lie ahead.”
Position Size – Refers to the size of one investment in comparison to the total amount of equity invested. In other words, if you have $10,000 invested in 2 positions, your risk is said to be greater than if you had $10,000 invested in 5 positions. The basic reason is simple: if 1 of your 2 positions drops by 10% while the rest remain even, you’d end up with $9,500; however, if the same scenario occurs and 1 of your 5 positions drops by 10%, you’ll end up with $9,800. Of course, the inverse is true too… if the one investment goes up, with the 2 position portfolio, you’ll end up with $ 10,500 compared to $10,200 with the 5 position portfolio.
Dollar Cost Averaging – When investors create a forced savings plan and invest it into a specific investment that changes in value over time, what they are doing is dollar cost averaging. It is based not he principle of investing equal amounts of money regularly and periodically over very specific times (i.e. a monthly contribution). Dollar cost averaging involves a fixed amount, a specific time, and a time horizon over which the investment is made in a given asset. While this is most commonly used as a purchase plan, it can equally be used as a selling strategy too.
Evidence of Misapplication
Unfortunately, too much of a good thing can lead to unwanted results. If you apply with these strategies to their extremes, you’re left with the following possibilities:
Own Everything – Instead of investing in a select stock, for example, that you’ve determined to be best in class with strong fundamentals and world class leadership, you get a basket of goods… which include stocks that on paper show no sign of hope. Worse yet, you may end up owning a stock with huge debt, few sales, and only “trial” products instead of reliable consumable assets. While Mutual Funds, Index Funds, and other forms of investments offer diversification, many investors still lose significant amounts of money owning small portions of so many assets.
Own Nothing – Investors can create so many positions to help hedge their risk that they end up hedging against increases in their portfolio too. As the example demonstrates in position sizing, it is possible to minimize risk to such an extreme that investors also minimize their returns, feeling no noticeable gains despite one or two positions rising significantly over time.
Own the Good and the Bad – Dollar cost averaging (DCA) is a great savings technique, but as an investment strategy to minimize risk, it simply doesn’t work. In fact, it increases risk. Unfortunately, this deserves its own article… but for now, I’ll try to provide a snapshot. Let’s take a look. First, DCA often lulls worried investors into investing more into a market than they would likely do all at once. Instead of investing a set amount, investors tend to set it in auto-pilot and forget about it, leading to a greater position than anticipated. Second, DCA exposes you more to the markets, increasing risk, as you continually add to your positions greater amounts of your wealth, despite the fact that those positions might be losing value. Why would anyone put more money into a losing venture, merely hoping it might turn around? I could go on… but since this is a subject that deserves it’s own attention, we’ll come back to it in a future article. For now, all you need to know is that DCA may actually increase your risk, not minimize it.
Join me again in a few days when we’ll take a closer look at specific ways investors can develop and apply risk management techniques that work to preserve capital, minimize risk, and maximize returns. After all, if you’re going to be a successful investor in the stock market, you’ll need to apply risk management techniques.