Financial Risk Management: 6 Ways to Reduce Your Investing Risk & When to Re-Enter a Stock After You've Stopped Out
by Alexander Green, Chairman, Investment U
Monday, June 11, 2007: Issue #682
Last week I had the opportunity to speak to a group of investors in Jackson Hole, Wyoming.
Jackson Hole, as you may know, sits just south of the Grand Teton National Park. Nine million years ago, the Grand Tetons didn't exist. The land around Jackson Hole was just a high grassy plain. But then a 40-mile-long fault opened up. And once every nine hundred years, the Tetons experience a really big earthquake, pushing the mountains about six feet higher.
That nine hundred years is an average, by the way. According to geologists, the last major Teton quake occurred between five and seven thousand years ago. That makes the Tetons just about the most overdue earthquake zone on the planet.
Just north of the Tetons, of course, is Yellowstone Park. It's even more interesting from a geological standpoint.
According to Bill Bryson, author of A Short History of Nearly Everything, "The entire Yellowstone National Park is a dormant supervolcano that sits above a magma chamber, 45 miles long, with the explosive potential of an eight-mile-high pile of TNT that would cover the state of Rhode Island If it blew, the consequences that follow would be beyond imagining."
He notes that the Yellowstone supervolcano has erupted more than 100 times over the past 16.6 million years, with an eruption cycle of approximately 600,000 years. Interestingly, the last time it exploded was about 630,000 years ago.
So why were we holding a meeting between the world's most overdue earthquake zone and the planet's largest active volcano?
Why, to talk about financial risk management, of course. And it turned out to be a good week for it.
Six Ways to Reduce Your Financial Risk
Following a rate hike in Europe and nervousness over oil prices, the Dow plunged over 400 points in three sessions before rebounding on Friday. Analysts are now furiously debating whether this was merely a minor hiccup or the beginning of something more ominous.
We'll never know for sure until we're looking in the rear-view mirror. But there are plenty of things you can do right now to lower your investment risk profile.
Two weeks ago, I noted that the current bull market, more than four-and-a-half years old now, is getting a bit long in the tooth. And I offered a few words to the wise:
- Consider investing in less economically sensitive stocks, like utilities, pharmaceutical companies, food companies and defense contractors.
- Reduce your exposure to small-cap stocks, which get hurt more in a down market.
- Spread your risk among foreign markets, gold shares, bonds, real estate investment trusts and inflation-adjusted Treasuries.
- Pay off your margin balance, if any.
- Eliminate your speculative holdings and lagging stock positions - and close out your call options.
- Tighten the trailing stops behind your individual stock positions, to protect your principal and your profits.
Using trailing stops to protect your stock positions gives you a sell discipline. You're not just hoping that earnings grow and the market advances. You've taken out insurance in case anything goes awry.
It means a small loss never becomes an unacceptable loss. And profits don't slip through your fingers.
However, one attendee at the Jackson Hole meeting asked me a good question. "When you stop out of a stock, how do you know when to get back in?"
While there are few hard and fast rules in this area, here are my general guidelines.
What's Dragging Shares Lower?
If you stop out of a stock because the company is suffering from serious problems, think long and hard before buying the stock back. I'm talking about a big earnings miss, a product recall, harmful legislation (or litigation), intense new competition, or any serious bad news.
In these instances, the stock is dropping due to specific, negative factors. It's unrealistic to think problems like these will be solved immediately.
On the other hand, if you stop out of a stock because of a falling market, you might potentially reenter the position fairly quickly.
A good example is Wal-Mart de Mexico (OTC: WMMVF). In the market drop following 9/11, we stopped out of Mexico's largest retailer in our Oxford Trading Portfolio.
However, we couldn't imagine why this event would cause Mexican consumers to suddenly turn away from lower prices and greater selection. So as soon as we felt the selloff had run its course, we put the stock right back in our portfolio. Five-and-a-half years later, our shares are up 322%. And we're still running a stop loss behind our position.
The lesson is this. If you get stopped out, ask yourself whether the market is to blame or the company's management.
If it's the latter, wait until the stock is back in a confirmed uptrend before re-entering the position. If it's the former, buy back in as soon as the market stabilizes.
As we discussed in Jackson Hole last week, doing so should help keep you on stable ground.
Today's Investment U Crib Sheet
- As a rule, Alex recommends running a 25% trailing stop behind stock positions. Of course, there are exceptions. And Wal-Mart de Mexico is one of them. Here, Alex recommends using a 35% trailing stop. That's because it's a slightly more volatile holding, and the wider trailing stop will absorb steeper price fluctuations. Gold shares are volatile, too, and are another class of stocks that could benefit from a 35% trailing stop.