Risk Management

The second element of Natural Selection Investing is risk management. As an investor, I am not comfortable with large draw-downs in my capital base that are typical of riding out bear markets or market crashes. Perhaps the strongest component of risk management is contained within the trading system’s defining characteristic, which is that stocks and ETFs are only held if they are trending up (i.e survival of the fittest!). Ageing trends are discarded in favour of emerging and established trends on an ongoing basis, which inherently reduces the probability of broad portfolio losses.  Despite this reality, diligent risk management is applied to each investment and across varying market conditions. 

Stop Loss Management

My system focuses on the complete management of an investment from initial buying through to taking profits on my ageing investments. At the outset of any trade within my portfolios, an initial stop-loss is entered into my portfolio-tracking spreadsheet in case the trade moves against my position beyond what my analysis considers reasonable. The chart below provides an example of how initial stop-losses are placed.

The initial stop-loss serves the purpose of keeping potential losses small, while allowing winning positions to run higher. As individual positions trend upwards, stop losses are raised to the next logical level based on the system parameters. This means that at any given time, I know exactly how much capital is at risk both in the event of an initial stop being hit and also in terms of my profit-taking sells. As with any trend trading strategy, the goal is to stay in the trade as long as possible but not overstay your welcome. This means not giving back big gains but still being patient and flexible with your sells. Once the trend is fully underway and the trade is guaranteed to be profitable, I tend to widen the stops to allow the trend to run for as long as possible. Typically a clearly identifiable lower high and lower low are the most reliable indicators that a trend is ending but the stop-loss utilized may vary depending on market conditions and investor risk tolerance. Cautious investors will typically sell ageing trends earlier than those who are okay with more risk.

Diversification

Diversification is often heralded as the primary mechanism of risk management and I certainly believe that it has benefits, especially in positively trending and stable markets. Being exposed to few sectors can lead to large losses when an inevitable sector-wide correction occurs, as is occurring in both the energy and marijuana sectors at the time of writing. When identifying candidates for my stock portfolio, I am careful not to overload any individual sector and instead seek the best trending stocks from a variety of sectors. This is less of an issue in the ETF portfolio where the funds to choose from represent various global markets, sectors, commodities, and cash equivalents, meaning the diversification is already present in the portfolio.

Managing a Bull to Bear Transition

One of the primary concerns that investors have pertains to what happens when the market finally rolls over into bear territory. Won’t all of our holdings be dragged down with it and stopped out? It is certainly true that strong bear markets tend to be characterized by indiscriminate selling of weak and strong stocks alike. Typically, the selling begins with the weakest companies and eventually migrates to strong companies as well. I pay close attention to general market conditions that may indicate that things are starting to break down. For example, a broad market that is trading below its 200-day moving average (dma) warrants caution, as does a loss of market breadth (having very few market leaders).  In cases of general market weakness, my strategy is to tighten stop losses on open positions, hold a higher ratio of cash (including 100% cash if warranted), and invest in inverse index ETFs, which allows me to capture any further upside in my long holdings, while simultaneously benefiting from the broader market weakness. If the market were to experience a full-scale crash, the inverse position would partially offset any losses in my long positions and give me time to liquidate my remaining longs. So, while buy and holders are stuck watching all of their holdings trapped in a bear market, natural selection investors are safely on the sidelines looking for their next opportunity.  I employ these strategies in both my stock and ETF portfolios, which I had to do in late 2018 when global markets were in correction mode.   NEXT

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