Risk is an inevitable part of our everyday life. Whether you are driving down the highway, eating unhealthy foods, changing careers, or betting on who will win the big game, there is always some level of risk. Aspects of this risk can be reduced, but eliminating it completely is nearly impossible.
Investing risk works much the same way. Any asset class comes with its own unique set of risks, whether it is investing in real estate, gold, stocks or bonds. Even a decision to not invest and remain in cash is a risk due to missed potential opportunities and most importantly the risk of the value of that cash eroding due to inflation.
At Lakeview, we believe that the best way to deal with risk is to have a plan in place before it is needed. Establishing a risk management discipline will reduce the number of emotional decisions that need to be made during a challenging period. Below are the circumstances which may cause us to sell an asset as part of our risk management discipline.
Deterioration in a company, industry, or assets fundamentals are seen as a possibility. We invest with a long-term view and know there will be up and down periods for all assets. However, if our original fundamental thesis for investing in an asset no longer appears to hold true, it is likely time for us to move on.
New opportunities provide better risk versus reward potential and/or the security is reaching our upside price target. These two often go together because if a security we own has increased enough to approach our price target, then most likely there will be better opportunities for us to shift towards.
A regularly paid dividend is cut. While we do not invest exclusively in dividend paying companies across all of our strategies, we do believe those that pay a regular dividend and are forced to cut it may be signaling a deteriorating change in their cash flow and future prospects.
Our preset stop loss level is reached. Before we initiate a position in any equity security we establish a stop loss level for us to sell. This level varies depending on if we view the security as a core position, or a more tactical opportunity, as well as other circumstances. As the position hopefully increases in price over time we raise the stop loss level. We believe in letting our winners continue to run, as long as none of the above criteria is met, and cutting our losers. This allows our best holdings to compound over time, while not allowing our small mistakes to turn into big mistakes.
A deteriorating price trend. On occasion we may sell if the absolute and/or relative security price trend is worsening even though it has not yet declined to our stop loss level. This would most commonly be done in a more volatile tactical security in an attempt to try and reduce potential loss.
As of mid-December the S&P 500 had crossed above/below the 50-day moving average 39 times and above/below the flat line for the year 24 times. Both of these are records. This type of whipsaw action will cause some of our risk management discipline to sell securities that then turn higher and to have to sell some securities we just recently purchased. No one knows which minor correction will turn into a big down move until after the fact. By following our risk management strategy, we believe that over the long-term assets will be preserved and ultimately grown. New opportunities will always present themselves over time. If we have protected capital during the turbulent times, we will have the capital to take advantage of those opportunities.
Source: Brian Boughner, CFA, CMT