Aaron 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.
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.
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:
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.
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.
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?