Be Your Own Chief Risk Officer
Let me make one thing very clear: Being a good stock picker is never enough.
If you want to be a successful investor, you’ve got to do more than just find stocks that are likely to go up. You’ve also got to figure out how much to invest in them. You’ve got to figure out when to invest in them. And you’ve got to figure out when to avoid stocks altogether.
In other words, all of the world’s best investors are great risk managers first and foremost.
That’s not something that you’ll hear on CNBC or in The Wall Street Journal. That’s because those publications need to sell excitement. And let’s face it, talking about managing risk isn’t as sexy as shouting, “BUY XYZ! IT’LL MAKE YOU RICH!”
The irony is that being a good risk manager will make you rich.
Today, I want to show you why you should spend more time being your own chief risk officer.
In the institutional investment world, a chief risk officer — or CRO — is the one who makes sure that the investment decisions a fund or firm makes can’t destroy the entire portfolio. When a CRO does his job, he should be invisible. But the most conspicuous risk management stories come from the CROs who didn’t (or couldn’t) do their jobs.
Take the MF Global debacle from late 2011 — the firm lost $1.6 billion of customer funds after blowing up its own proprietary trading account in October 2011. That’s just a handful of months after the firm fired its former chief risk officer, Michael Roseman, for waving the red flag over the bets that were being made. Bear in mind that MF Global was actually right about the investments it made. The firm just didn’t survive long enough to see its bets bear fruit.
If that doesn’t show you the value of being a good risk manager, nothing will…
More importantly, if major firms are paying huge salaries to hire CROs to keep an eye on their portfolios, why wouldn’t you want to apply the same principles to your own portfolio? Here’s a glimpse at three things you can do to effectively manage risk for your investments:
1. Pick the Right Position Size
One of the fastest ways to lose a ton of money in the market is by picking the wrong position size for your investments.
Let me show you how the professionals do it…
First off, when you’re deciding how many shares of a stock to buy, the ONLY thing you should be thinking about is the amount of cash you can have at risk. Not share price. Not the number of shares you buy.
Once you’ve figured out how much cash you can risk, you’ll want to back into how many shares you’re buying. Ultimately, factors like share price are just noise — if you make 10% on 1,000 shares of a $1 stock or on 10 shares of a $100 stock, you’re making the exact same amount of money.
2. Determine Stop Loss Levels Before You Buy
Another critical risk management tool is the stop loss.
A stop loss is an order with your broker to sell your shares in a particular stock automatically when its price hits a specific level. Stop losses go hand in hand with position size — after all, the distance between a stock’s current price and your stop is the risk you’re exposed to as an investor.
Stop losses should be placed at a level so that they trigger when you’re wrong about a trade. Usually, that means that you want to put a stop just below an important support level.
That means you should be able to identify where you’re going to put your stop before you even buy the stock. I won’t ever enter a trade without knowing my stop loss before I click “buy.”
3. Don’t Fear Cash
You may have heard that “Cash is a trade.”
It’s true — even though it may feel like you’re doing nothing by sitting on cash, it can be every bit as valuable as having an open trade. Owning a portfolio that’s 100% cash isn’t the same thing as being gun-shy about your trading. When the market’s out of alignment, you need to approach a cash position as an active position just like any stock or option you buy. Contrary to popular belief, having a portfolio full of cash is “doing something” in this market.
Part of the reason cash is such a crucial position to take at times is the fact that markets don’t just go either up or down. Instead, volatile markets can easily whipsaw you out of positions as stocks churn sideways.
In my experience, during times when my active trading system has signaled an exit from my open trades, I’ve avoided double-digit losses in the broad market by sitting on cash until the next trading signal said to buy. It’s a psychologically hard signal to follow, but going to cash at the right time can do wonders for your risk exposure.
Jonas Elmerraji, CMT
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