Risk control Through Selling and Diversification
It is better to sell with a small loss than with a big one. Diversification is one of the means by which an investor can minimize a losing position’s negative impact on a portfolio. The inconvenience of tracking a diversified portfolio is preferable to watching a non-diversified portfolio’s value melt away. A comprehensive risk control strategy is based on individual position size relative to the whole portfolio, limiting the amount of decline permitted, and maintaining a ready supply of candidate replacement stocks that are more likely to rise than decline. The last of these is important because weak stocks are riskier than strong stocks, and it is natural for an investor to have internal resistance to selling a weak stock at a loss. The availability of alternative stocks likely to rise soon eases that resistance, and selling weak or declining stocks is an important part of a good risk control strategy. Monitoring a watch list for promising setups can provide investment alternatives and make it easier to reduce risk exposure by replacing weak stocks with strong stocks..
When the market is volatile, "loss control" is vital. Suppose, for example, that a portfolio incurs a loss of 15%. To break even, it would have to gain about 17.5%. Such a gain may not be that difficult. However, a loss of 50% requires a gain of 100% to break even. It is okay to allow a stock to drop 20% before selling if the stock represents only a small part of a portfolio. However, when position size is large (when the stock represents a relatively large part of a portfolio), losses must be kept under much tighter control. An investor cannot know in advance the extent of any stock decline. He does know for sure, however, that he must act before the loss becomes too great. At some point, he must sell even if he believes in the stock and thinks it may reverse at any moment. That is the part of risk control that takes discipline.
Let’s assume you have a profit and that the stock is no longer advancing (it’s going sideways). You have a "watch list" and you notice that there are several stocks that have attractive "setups." By definition, a "setup" gives a much higher probability that a stock will move in an anticipated direction. Now the question becomes, "should you sell and buy a stock that has a good setup or should you stay put?" Why sell? The stock may be topping out and preparing to decline, it may continue sideways for months, or it may be consolidating in preparation for another ascent to higher price levels. You do not really know what it will do next. If there is a pattern of increasing volume when the stock rises and decreasing volume when it declines, you may infer that when it breaks out of its trading range it is more likely to do so on the upside. However, in the absence of such clues, the gain you have achieved is at greater risk than when the stock was climbing. If you don’t sell, you may lose part or all of your profit. Alternatively, the stock could remain in a trading range for 6 months. Either way, your prospects would seem to be improved by a switch out of the position to something that is more promising. Having your money in a stock that is going up is preferable to having it in a stock that is going sideways or down. If, after you sell the stock, you see it break through the upper boundary of its trading range, that event would be a "trigger event" calling for a repurchase of that stock. Under those conditions, risk would be much less, and the stock would have signaled its "intent" to go higher.
Assume that instead of a gain you have a loss of 15%. For a relatively large position, it is unwise to let a stock drop much more than this before taking action. You can still be pretty confident that you will be able to gain back the loss and more. However, if the stock slips further, damage can increase to an almost unrecoverable level (it’s a process of stealthy or "creeping" decline in which things look fine; then, before you know it, the stock is down another point). Eventually, a small loss becomes a major loss. It is possible to recover from a major loss, but it is not easy. It is better, by far, to limit loss in the first place rather than to have to repair damages incurred by ignoring an obvious need to act. This is where a "watch list" can be a big help and enable you to get a significant boost in performance. Stockdisciplines.com traders always have a "watch list." You can profit by following their example. Monitoring such a list will make you aware of stocks that are in a "setup" configuration that promises a price surge soon. Thus, money could be shifted from a stock that is stalling to one of these when an appropriate "trigger event" occurs.
Another tool of use in controlling risk is diversification. Many people like to limit their portfolios to as few as 5 stocks. They just want to keep things simple. However, increasing diversification will reduce the significance of any future downturn in any single stock. For example, if a stock represents 40% of your portfolio and it drops 30%, your portfolio will lose 12% of its value. Though this might be a manageable loss, you could not tolerate many repeats. On the other hand, if the stock is only one of 15 equally weighted stocks (and therefore represents little more than 6% of your portfolio), the same drop will cost the portfolio less than 2%. Thus, you have more "wiggle room" when dealing with a declining stock. Of course, the "stops" described here are based on the assumption that there is an even distribution of assets among your different portfolio positions. If this is not the case, the amount of decline that can be tolerated for a stock will be determined by the amount of assets that are concentrated in that particular stock.
Also, even top portfolio managers who usually let stocks drop 10% to 20% will sometimes "pull the plug" after only a 7% loss or less. They do this at times when stock behavior patterns can be defined sharply enough that breakdowns are very evident. An investor can tolerate twice as many 7% losses as 15% losses. What does this mean? It means that when the market becomes very expensive and stocks are more likely to break down, professional managers will tend to tighten their stops. That is, they will tend to sell more quickly because waiting for a stock to recover from a major sell-off becomes increasingly risky under these conditions. Stocks can work their way down slowly (but sometimes quickly) 50% or more and then stay there for several years. If this happens, the opportunity loss, to say nothing of the drop in value, can be staggering. In short, investment style, time horizon (short-term traders vs. long-term investors), market conditions, portfolio weighting considerations, and the volatility of the particular stocks that are in the portfolio all can have a bearing on the amount of loss that can be tolerated.
The important point is the need for some discipline in maintaining damage control. The value of your portfolio must be protected when stocks are in decline. Letting money become relatively dormant for six months is not good stewardship either. The market has many opportunities for growth. It is far better to abandon non-performing positions to take advantage of such opportunities when they occur, than to leave assets in a state of dormancy or heightened risk. Increasing volatility also suggests the need for more diversification. Spreading assets among more positions enables you to weather greater declines in individual stocks with less damage to your portfolio.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses