Seeing your investment account go down in value is never a fun experience. Experienced investors understand risk and work to minimize losses by employing stop-loss or other risk mitigation strategies.
For years I’ve used a stop-loss strategy to protect clients’ principal. I’m writing this post to give you insight into our risk mitigation philosophies.
Basics Of Risk Management
The unfortunate truth is that risk is inherent in all financial decisions. Even a fixed bank investment runs the risk of losing purchasing power due to inflation.
Investment Risk is quantified using volatility determined by an asset’s change in price compared to its historical averages over a period of time.
Investors can expect larger gains and larger losses from more volatile or riskier assets. That is why understanding and mitigating risk is very important to accomplish investing goals.
Every portfolio should have a different level of risk because every investor is investing for a different reason. Investors should understand the risk inherent in an asset, and invest in portfolios with a volatility that matches their tolerance for risk.
My role as a financial planner is to help clients understand their tolerance for risk and then build a portfolio to match their goals and then actively manage it to avoid losses and help it grow.
Avoiding A Big Loss
When most investors decide what to invest in, they often fixate on the possible gains and forget to consider the possible losses. This is a problem.
The math of percentages shows that as losses get larger, the return necessary to recover to break even increases at a much faster rate.
If a stock fell 7-10% I would sell the stock. This would leave me 90+% to build up the account with.
The theory is, if you lose 10% on a trade you need 11.12% to build it back to even. That’s doable.
If you lost 20% on a trade, it would take 25% to build it back up to even. Not as doable.
And if you lose 30%, it would take 42.86% to build it back up to even. This is a problem.
But things get worse as the numbers continue on. A 50% loss requires a 100% gain to recover and an 80% loss necessitates 500% in gains to get back to where the investment value started.
The key to recovering from a loss is to mitigate loss in the first place.
Because big losses are very hard to recover from, having a stop loss or some way to quantify risk is critical to building wealth.
If you leave a stop-loss order on overnight or “good till canceled”, trading volume can slow up especially overnight and the stock can trade down to your stop-loss taking you out. It’s not fun to see your stock up only to find out that you were stopped out overnight for a loss.
I now use alerts that let me know when a stock has reached a sell point.
I like being able to assess if the downturn in the stock is a material issue that should be sold or just market conditions. Some people refer to it as a broken stock or a broken market. This helps keep you from getting “shook-out” of a quality stock.
The downside is, if a stock moves down sharply you can blow past your stop-loss limit giving you a loss greater than expected.
Using Options to Quantify Risk
(If you do not know what a stock option is, read our block about stock options.)
I’ve found that buying a ‘call’ option to buy a stock can cap your potential loss.
If I like ABC company at 100 a share, I can buy the stock for $100 with a stop loss at $90 or I can buy a ‘call’ option for $10. So what are the pros and cons?
Pro – loss will not be greater than $10 and I won’t get shook out. I commit less capital upfront. If the stock moves up I can see a sizable gain in the option price.
Con – If the stock does not increase above $110 (stock price + option price) the option can become worthless.
Options are not always appropriate; you should have confidence the stock will move above the option price and at the money stock price. Also, you don’t get the paid dividends holding an option. So keep those things in mind.
Another way we use options is by selling a ‘put’. By selling an option, the buyer pays us a premium. In the case of a ‘put’ contract, it’s to sell us the stock or ‘put’ it to us at an agreed-upon price. If I like ABC stock but feel it’s too pricey at $100 but like it at $90, I can sell a ‘put’ contract with the hopes of buying the stock at the better price or collecting the option premium if it doesn’t reach our buy price.
Pro – You collect an option premium regardless of the direction the stock goes and you might be able to buy the stock at a more desirable price.
Con – Your earnings are capped by the option premium. If the stock falls below the put price you are obligated to buy the stock at the put price even if it is worth less than that.
What Should I Do to Manage Risk?
Choose an advisor that not only has an investment entry strategy but also an exit strategy. Many people understand the theory but lack real experience with risk mitigation. With so many variables to consider this is an area where the science of investment becomes more of an art.
My team and I have been developing our risk mitigation strategies for years, and although not perfect, we feel we have developed strong skills in this area and are excited to show you what we can do for you. If you’re interested in learning more, go ahead and reach out to our team.