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Investment Risk Management Strategies – 5 Ways to Play Defense

By Kim Petch

money chains defenseAaron Rodgers and Greg Jennings may get all the glory when it comes to reliving the big Super Bowl plays of 2011, but it wouldn’t have mattered how many points the Packers put on the board if they didn’t have a strong defense as well.

In other words, a good offense can’t be successful without an effective defensive program. And the same is true for your investment strategy.

Here are the best strategies to protect yourself when it comes to the game of investing.

Investment Offense

In terms of investing, there are numerous approaches to offense. You can invest aggressively in high-flying momentum stocks, buying into the most successful companies on the expectation that they will continue to outperform. Apple (NASDAQ: AAPL) is a good example of a company where this approach would have worked well. The stock has definitely risen a lot, but it has also had the fundamental growth to support the price appreciation.

Alternatively, you could take a more conservative approach to offense. Rather than investing in the companies with the most momentum, you can identify stocks that might be undervalued. Some investors like to wait for their target investments to hit a specific valuation or price based on fundamental or technical analysis before they put their money to work.

Regardless of which method you choose, you’re looking to generate some capital appreciation. When you play investment offense, your primary goal is to grow your money.

Investment Defense

A successful offensive campaign is great. What could feel better than watching your investments grow? But defense is important too. Imagine how you would feel if your investments didn’t grow? What if they actually lost money? If you’ve been investing for any length of time, you probably know that losing money isn’t much fun.

Warren Buffet, one of the most successful investors ever, is famous for spelling out the two most important rules of investing:

Rule #1: Don’t lose money.

Rule #2: Never forget rule #1.

That’s defense. While it’s a good idea to take some risks in order to grow your savings, it’s also imperative that you have a system in place to limit that risk and protect your capital on the downside. The following chart shows how much of a gain you would require to make back a given loss:

loss incurred gain required

You can see that even a relatively small loss can require a pretty big offensive push to recover – especially with brokerage and investment fees involved. It’s easy to say that you’ve got to control your losses. But how do you do it?

5 Ways to Manage Investment Portfolio Risk

1. Follow the Trend
The trend is your friend until it ends. One way to manage investment risk is to commit to only buying stocks or Exchange Traded Funds (ETFs) that are in an uptrend and to sell them once they violate their trend line support. You can draw your own trend lines by connecting a series of higher lows on a chart, or you can use a moving average like the 50-day or 200-day to act as support. If the price breaks that support level by a predetermined amount, you sell.

2. Rebalancing
Longer term investors may try to manage risk by periodically selling stock investments or asset classes that have come to take up too much of their portfolios. They will sell off those assets and buy more of the stocks or ETFs that have underperformed. This can be a forced means of buying low and selling high.

3. Position Sizing
Another way to play defense is to simply limit your exposure. If a given investment is riskier than others, you can choose not to invest in it or to invest only a small amount of your capital. Many investors use this type of approach to gain exposure to riskier sectors like biotechnology or small cap stocks. A 50% loss on a $2,000 investment hurts a lot less than it would on a $20,000 investment. The easiest way to lower your stock market risk is to shift some of your capital to cash.

4. Stop Loss Orders
You can place a stop loss order with your broker that will automatically sell out all or part of your position in a given stock or ETF if it falls below a preset price point. Of course, the trick is to set the price low enough that you won’t get stopped out on a routine pullback, but high enough that you will limit your capital loss. Placing a stop loss order is one way to limit the damage to your portfolio and force yourself to follow a strict defensive discipline. Moving or ignoring stop loss levels almost always results in greater losses in the end. The first exit is the best exit.

5. Diversification
The idea behind investment diversification is to buy asset classes or sectors that are not correlated. That means that if one goes up, the other is probably going down. Diversification has been a lot more difficult to achieve over the past few years as many asset classes have become highly correlated. Even stocks and bonds have been moving in the same direction much more often than in the past. Diversification is a good strategy to limit your risk, but it only works if the assets you buy are truly uncorrelated. Make sure you look at relatively recent performance rather than relying on historical relationships that may no longer be working.

What defensive strategies do you use in your investment portfolio?

(photo credit: Shutterstock)

Kim Petch
Kim is the writer behind Balance Junkie, a blog about personal finance, economics, investing, and life balance. You can also find her articles featured on Seeking Alpha. She's a big fan of her three sons, paying down the mortgage and baseball - in that order.

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  • howard

    You have got to be kidding. This may be one of the most inane articles ever written. Lets review the basics

    1. Never lose money- Well then never invest in anything but a CD……
    2. Follow stocks with Momentum. Thanks who knew..
    3. Look for undervalued stocks. Another pearl of wisdom
    4. Rebalance, position size, diversify etc. Really? What a concept……….

    Ok if you are writing to a group of high school students then this might be some things they should know before they risk their hard earned money. but if you have to write this for adults with money then we have much bigger issues.

    • http://www.moneycrashers.com Kim Petch

      Perhaps you’d like to submit an article that corrects the major errors you see here? We could leave it open for comment and let others bask in the glow of your wisdom.

      • howard

        Kim

        It is not that what you said is “wrong” it is that it is like saying “be careful what you touch it may have germs”. It’s like being in favor of Motherhood.

        Rule number 1 “don’t lose money”.A better article would have at least given examples of how you do that (which of course is impossible).

        What you wrote has been written a thousand times before and does not add to the knowledge base of any investor. Asking me to submit an article is not the correct response since I did not write the original article nor was it I that was offerring others advice.

        Here is one specific item that that I offer to counter one of your recommendations:

        STOP LOSS ORDERS

        It is not a good recommendation to give your broker your stop loss order. Market makers take all the stop loss orders and will have the stock just touch them and trigger you out of the stock prematurely. Also
        are you aware that studies have been on proper stop loss orders that show they should not be less than 16% to not be taken out of a position prematurely?

        • http://www.moneycrashers.com Kim Petch

          I understand your complaints and I can’t completely disagree with your major points, except to say that you were impolite in your delivery. However, this site is not directed at sophisticated investors. I’m sure Mr. Buffet didn’t mean that it was literally possible to “never” lose money any more than I did. The point was that limiting losses is just as important as maximizing gains. I thought that was self-evident.

          On stop losses: I actually agree with you and I haven’t been great at implementing them properly in the past myself. I offer them only as one tool. They aren’t right for everyone. I know of many successful investors who use them as their primary means of risk management. I know of others who think they’re more risky. The idea is to offer some different options to readers and let them decide which strategy works for them.

          A detailed discussion of any one of these factors is beyond the intended scope of this article. It was written for folks who aren’t already aware of this information. Believe it or not, that includes a lot of people. So for some, it probably did add to their knowledge base.

          You may have considered the article inane, and we can debate whether or not it’s polite to say so, but others hopefully learned something new and used it as a starting point for further study. I’m sorry you didn’t find it useful, but thanks for reading anyway.

  • howard

    Kim

    I accept your response. I guess my expectations were high since you also write for Seeking Alpha.

    If we tell people the first rule is never lose money then shame on us. The first rule, better stated, is protect your wealth and minimize losses.

    By the way alot of people really do not understand how to use Stop Losses so some numerical examples would probably be useful. Particularly if you are using Trailing Stops rather than fixed stops.

  • http://www.moneycrashers.com Kim Petch

    I do write for SA, but I know that I’m writing for a completely different audience there. Many SA readers know a lot more about some areas of investing than I do. You are probably one of those.

    Your first rule is a good one, and perhaps captures the point of the article better than my Buffet quote.

    Stop losses are an enigma for many, including me. I have yet to master them, but I haven’t given up trying altogether. Perhaps I’ll write a more detailed post at some point that outlines the pros and cons of stop loss orders as well as the many ways you can use them – or choose not to use them.

    Thanks for the interesting discussion today Howard.

  • http://www.linkedin.com/company/finlandia-group-oyj Oona Hyypia

    You really did explain very well the investment offense.and also the investment defense.Good job.

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