Once you decide if you're really a risk management investor, it's also important to understand that despite what a FBB&A might have said, rebalancing a portfolio is not a risk management tool. This has been sold by the investment community for years and therefore it has become “gospel”. However, reality is real risk management takes rebalancing a step further by applying “lines in the sand” as to where you will sell off a position in the event of a decline in price. In some instances the use of downside price targets provides risk management that may also offer an opportunity to protect well-earned gains.
Deciding to employ a risk management technique means you must decide on the holding period and the level of turnover you are comfortable with. Some investors want to own a position for as long as possible but may also want to establish downside protection in the event of a decline in a position. The best way to accomplish this is to buy a position and then establish a downside target. Should the downside target be reached, the issue will be sold. Proceeds will be reinvested in one or more issues sometime in the future and the same downside process will occur again.
If an issue isn’t liquidated within a set period of time it might be best to adjust the downside price based on the performance and taxability of such a transaction. Another possible method of managing your downside risk is to increase your downside price as the issue appreciates in price. This doesn’t use a time element to managing your portfolio, but instead it uses a pricing component to manage risk.
The advantage of this type of strategy is that it allows you to benefit with the increasing price of a security with a liquidation price should the market turn lower after it achieves some sort of targeted appreciation. This will allow you to capture gains as opposed to the possibility of watching a stock increase in value and then subsequently decline in value.
Some FBB&A’s call this market timing. Yet, what they also won’t tell you is that while there are some great buy-and-hold investors (Carret, Lynch, Buffet, etc.), there are also some great risk management investors as well (Paul Tudor Jones, Jim Rogers, Bernard Baruch, etc.).
Tom is the Founder of TRG and has been the President and Chief Investment Officer since 2008.