Controlling Your Risk
This Week’s Fortune Cookie
In Case You Missed It
---In this week’s Stock Market Video, I look at the origins of Thursday and Friday’s market blow-up and advise everyone to have their loss limits in place. I also point out that growth stocks are much stronger than large-caps or industrials as a group, and that stocks have to be handled on a case-by-case basis. So it’s time to tighten up your stops and sell your losers, but don’t ignore the stocks that remain strong. Click below to watch the video!
Controlling Your Risk
With stock markets staging a county fair Destruction Derby on Thursday and Friday, I’m dumping my original topic for this issue in favor of a piece on risk. This is the equivalent of the newspaper stories that appear ahead of the first big winter storm that tell you to have candles, food and water in stock in case the weather turns really nasty. I hope it helps you deal with the market’s recent over-the-falls experience.
Risk is not a sexy topic. Many investors’ eyes glaze over when they read about it. But those who buy equities, especially those who come aboard during bull markets, invest to make money, and tend to think less about the possible downside.
Well, good investors do consider the possible downside, and in light of the market's recent stumble, now's a good time to review your risk.
Interestingly, in the contrary world of the stock market, investors' perception of (and interest in) risk tends to be highest near market bottoms (when risk is actually low), and lowest near tops (when risk is actually very high).
We saw examples of this last year, when investors were afraid to invest in China because of tales of past quarterly reporting irregularities, government interference and pollution. But as stocks rose, investors' fear of the market diminished! Lots of hot money came into Chinese ADRs (American Depositary Receipts) and many made big runs to new highs. Bottom line: Big market advances tempt investors, many of whom throw caution to the wind.
The fact is that we hear from way too many subscribers who have done just that—putting half their money into one stock (because they think that’s less risky) or failing to cut losses short. Of course, everyone has their own level of risk tolerance, but some of the above moves can lead to drastic results.
The key is to stay in step with the market and have a plan for how to deal with the individual stocks in your portfolio when the market hits an air pocket. Remember, the market wants to take your money!
So you should have a system in place that automatically keeps you out of such situations, so your emotions don't get out of control near market peaks. And that's the topic of today's discussion. Don't worry—this isn't a technical write-up on volatility, standard deviation and the like. These are just some common-sense ways to control your risk, so that the market's inevitable potholes never cause fatal damage to your portfolio.
Cut losses short:
Never take a huge loss. In these market conditions, you should cut all losses short at a maximum 15% below your buy price. Remember, that’s a maximum loss limit. Don’t let any stock take a bigger bite than that. Period. And if the market is acting crazy, as it has been on Thursday and Friday, you need to be ready to take action to protect profits and keep losses small. Don’t rely on hope and don’t let regret keep you from acting.
Use market timing:
Avoiding major bear market declines isn't difficult. You just have to stay on the correct side of the trend! Today, with our Cabot Emerging Markets Timer negative and other Cabot timing indicators approaching the danger zone, risk has increased. During these times, it's best to defer most new buying, and to build up some cash by being tougher on your poorest performers.
Diversify by owning at least five—and no more than 12—stocks when fully invested:
Don't put all your money in just one or two stocks! Sure, if you're lucky, you could make a bunch of money in a jiffy. But it's just as likely you'll end up with your portfolio down a bundle if things go awry. Instead, reduce risk by spreading your money among at least five stocks.
Always work toward selling your weakest stock:
When the market takes a slide, it usually takes the lagging stocks down first. So it behooves you to try to sell your weakest stock from time to time, even in good markets. In the Cabot China & Emerging Markets Report, I did this yesterday with one of our stocks and put two others on hold. If the market weakness persists, I’ll sell more on Monday.
Lastly, sell down to the sleeping point:
If you find yourself constantly worrying about what XYZ stock will do tomorrow, it's a sign that you're uncomfortable with your potential losses. The solution? Sell some shares! Investing should be profitable and fun; it's not worth losing sleep over.
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Tim’s Comment: Sometimes they are both astute, as when a value investor, who bought near (or even before) a stock's bottom, sells (taking a profit) to a momentum investor, who sells some months later at an even higher price for a profit. But sometimes they aren't. The very worst is the guy who buys at the very top and sells at the very bottom. One way to avoid being that guy is to ask what the person on the other side of your trade might be thinking.
Paul’s Comment: William Feather was a 20th century writer who’s now largely unremembered, but he had a huge following at one time. I think he was having a little fun poking at the folly of equity investing. But the same observation applies to anyone who sells something, from a used car to a celebrity autograph. And if both buyer and seller get what they want, it’s quite possible that each is astute. But both buyer and seller have to know what they’re doing. Caveat emptor!
In case you didn’t get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, there are links below to each issue.
With his tongue firmly in his cheek, Cabot Stock of the Month’s Chief Analyst Tim Lutts looks at how the rising and falling fame of celebrities mirror the rising and falling fortunes of growth stocks. He also gives the fourth of his series on Disruptive Stocks. Stock discussed: Simon Property Group (SPG).
Roy Ward, the resident expert at Cabot Benjamin Graham Value Investor, gives his take on my “Four Things You Can Do in the Water.” Not surprisingly, he sees value stocks as the best answer. Stock discussed: Abbott Laboratories (ABT).
In this issue, I write about earnings season, why there is one, why stocks react so strongly to results and how to handle your stocks when companies are telling the world what kind of quarter they’ve had. Stock discussed: 500.com (WBAI).
Chief Analyst of Cabot China & Emerging Markets Report
and Editor of Cabot Wealth Advisory