Risk Managment

Discussion in 'Trading' started by bignatty, Aug 5, 2002.

  1. bignatty


    I realize most people here are short term traders. I am a longer term investor who looks at things like fundamentals and earnings esimates, debt. etc. I would like to hear some of your views on risk management as it relates to longer term trading or investing. For example are stops necessary if a portfolio is spread over 20 to 30 stocks in various sectors. Averaging down is a no no in trading, but what about averaging down into a well researched company you intend to hold for 3+ yrs. I ask for your insight on this borad because it seems to me that you short term traders have some of the best ideas about risk and how to manage it.
  2. I understand about long term and diversified, but think of all the mutual funds out there that are long term and diversified but still losing their butts.
  3. RE: Stop-loss

    Whether you use a stop-loss order to limit losses or to protect open profits depends on your beliefs about how prices behave.

    You SHOULD use a stop-loss if your believe that prices "have momentum" -- that when a stock drops in price, it is more likely to drop further in price. This can happen if:
    1) the price is overvalued with respect to prevailing opinion about the company
    2) insiders are trading on negative news before it becomes public
    3) a certain price drop indicates a mistake in your fundamental analysis
    4) the company's fundamentals are directly impacted by market sentiment (e.g., underwater stock options mean that employees have less motivation to perform, low stock price prevents the company from making strategic acquisitions or raising capital needed to sustain its fundamentals)

    You should NOT use a stop-loss if your believe that prices are mean-reverting. This might occur if:
    1) the price drop is caused by a temporary panic or simple market volatility
    2) low price actually makes the company a take-over target ( which would boost the price)
    3) the company might initiate a stock buy-back program (boosts the price and gives the company the opportunity to raise more capital when times are more favorable)

    The point is that whether you use stop-loss or not depends on the reason for the price drop and the likely long-term impact of that price drop on the company and on future prices.

    RE: Averaging down

    At some level, averaging down is the opposite of employing a stop-loss order (except for one crucial aspect of risk management described below). With stop-loss, you reduce the position size as the price drops, with averaging down, you increase the position size as the price drops. Thus, the answer to whether you use averaging down then is the reverse of the logic for using stop-loss.

    Aside from the preceding argument that you SHOULD average down if you believe that you should NOT use stop-loss, risk management practice does restrict the use of averaging down. A major element of risk management is to restrict worst case losses. Limiting the amount of capital allocated to a given position is a big part of this. Although one might argue that a given stock is a "sure thing", there are innumerable ways to be unpredictably wrong after even the most thorough fundamental analysis (e.g., company CEO dies in a plane crash, "accounting irregularities" are discovered, new government regulation appears, etc.). The popular rule is that you should risk no more than a 2% loss of your capital on any one position. Thus, if a stock has the potential to lose one third of its value overnight, then you should not put more than 6% (= 2%/(1/3)) of total investment into that stock.

    Hope your investing goes well,