Risk Management vs. Letting Them Ride

Over the last 10 years we have experiencing a market period like no other. Certainly the market sell-off of 2000-2002 was so much tougher than 1987 "bear market" (that lasted for arguably a couple of months), 1989-1990 recession sell-off, 1994's stealth bear market, 1996's summer technology sell-off, 1997's prelude to the Asian flu, and 1998's Asian flu. Even some brokers who were around in 1974-1975 have said that the 2000 to 2002 sell-off was much harsher to investors. One of the things that I always espouse to mitigate disastrous markets is the use stop loss points in order to preserve capital. If one preserves capital one can come back from any market decline. In many ways, this suggestion flies in the face of the "buy and hold" philosophy. But I suspect that many investors do not hold on to that philosophy with the vigor they once did.

Now, let's take it a step further and look at a portfolio of 12 stocks with $150,000 managed in two different styles. In Portfolio #1, no risk management tools are used and you see that this portfolio of stocks have had some major hits and some that have not been hit as bad, much like this market. In Portfolio #2, risk management tools were used on the exact same stocks, limiting losses to 20% on each stock. Look below and you'll see that Portfolio #1 has fallen 52% while Portfolio #2 is only down 15%. Now, if both portfolios rally 12% in two years, Portfolio #2 will be back up to $159,000. However, Portfolio #1 will only be back up to 97,843. It will take Portfolio #1 six years at a 12% a year return to get back to $154,000. The moral of the story is that as tough as it might be to have most of your stops hit, limiting losses and preserving capital is the key to coming back from market like 2000 to 2002. And down markets like that one will surely happen again in one way or another.

As George Foster, major league outfielder, once said, "There are four parts of self that lead to success. The first part is discipline, the second is concentration, the third is patience, and the fourth is faith." There will always be opportunities if you have money to put to work. Have faith that the decisions you make are the best possible ones given the information at hand. No one has a crystal ball.

Portfolio #1: No Risk Management
"Let Them Ride" method.
Stock	Invested	Current	% Down
Stock A	10,000	2,500	-75%
Stock B	10,000	5,000	-50%v
Stock C	10,000	7,000	-30%
Stock D	10,000	5,000	-50%
Stock E	10,000	2,500	-75%
Stock F	10,000	9,000	-10%
Stock G	10,000	10,000	0%
Stock H	10,000	11,000	10%
Stock I	10,000	5,000	-50%
Stock J	10,000	4,000	-60%
Stock K	10,000	9,000	-10%
Stock L	10,000	8,000	-20%
	$150,000	$78,000	-52%

Portfolio #2: Risk Management
Using a 20% downside stop exit.
Stock	Invested	Current	% Down
Stock A	10,000	8,000	-20% (sold)
Stock B	10,000	8,000	-20% (sold)
Stock B	10,000	8,000	-20% (sold)
Stock C	10,000	8,000	-20% (sold)
Stock D	10,000	8,000	-20% (sold)
Stock E	10,000	8,000	-20% (sold)
Stock F	10,000	9,000	-10%
Stock G	10,000	10,000	0%
Stock H	10,000	11,000	10%
Stock I	10,000	8,000	-20% (sold)
Stock J	10,000	8,000	-20% (sold)
Stock K	10,000	9,000	-10%
Stock L	10,000	8,000	-20% (sold)
	$150,000	$127,000	-15%

As you can see from this example, the "buy and hold" or "let them ride" method does not fair well in a "bad" market environment, similar to the current one. The 20% downside sell method kept you in the game and most importantly, you'd have $64,000 in cash ready to go to work when the opportunity arises.