One of the key questions on the minds, if not the lips, of your patients is likely to be, “Am I going to be okay?” This has also become the most frequent question posed to us by our clients and friends. Of course, we deal in the realm of financial well-being, not one’s actual health.
We first must identify more precisely what our clients mean by “okay.” In less volatile times, most are referring simply to whether they will run the risk of running out of money while they are still alive. As the volatility of the market has picked up over the past 16 months and recollection of the Great Recession looms large in the memory of some, okay-ness has been more focused on the short run. What can I do to protect myself from the next downturn? We even heard the corollary by one person, “How can we be prepared to make money in the next downturn of the market?” He had just seen the movie, “The Big Short.” In other words, people are now telling us, “I might feel good about the long run; right now it’s the short term that concerns me most.”
The traditional advisor deals with this by refocusing attention on the long term, usually 20 plus years. This totally ignores the important fact that losses in the near term are more costly to your long run scenario than losses that occur later in life. We call this return-sequence risk. Recent studies call into question the effectiveness of a static asset allocation that remains the same over long periods. Such thinking defines risk as volatility. If risk were defined as the loss of capital, one antidote would be a trading plan coupled with strong risk management. Let’s explore some of the elements of such a plan.
Have a positive expectancy. Develop a system and select investments with a rational mathematical expectation of positive return. Although you fully expect it to go up, decide ahead of time when you will get out if you are wrong and the market moves against you.
Place and move stops. When a trade is entered, a stop level should be set — that is the point at which you would accept a small loss and exit the position. If the position that you have purchased does go up, move up the stop. This is called a trailing stop. We prefer soft stops (those without an actual order) that serve as alerts for further evaluation.
Set a maximum allowable risk for any trade. Some use two percent, we prefer a max of one percent. So let’s say that you have $500,000 in your account. This rule limits your maximum risk on any trade to $5,000. Further, let’s say that you decide you are going to buy a stock valued at $80 and put a stop just below support at $75. That means that dividing your maximum risk per position ($5,000) by the risk per share ($5) allows you to buy not more than 1000 shares.
Set a maximum monthly drawdown. Set a rule for the maximum loss that you will allow in your portfolio on a monthly basis. We suggest six percent but that may vary with your tolerance for risk. This rule prohibits you from making any new trades for the rest of the month when the sum of your losses for the current month plus the risk of your open positions exceeds six percent of your account equity. Simply take a break from trading or find something to sell to reduce the risk currently in your portfolio.
Diversification is still a good idea, even in trading systems. Overconcentration of one security or one asset class can be ruinous. Likewise, loading the portfolio with highly correlated securities that move in lockstep with each other should also be avoided.
If you would like to know more about these concepts, I suggest Dr. Alexander Elder’s book, The New Trading for a Living.
Scott Neal is president of D. Scott Neal, Inc. a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Call 1-800-344-9098 or email to scott@dsneal.com.