This article explores various risk management strategies. In an investment world that is full of analysts and others that profess to know what is going to happen in the markets, some level of risk management is appropriate to recognize the fact that nobody truly knows what will happen in markets. I’ll discuss how I use, or have used, each strategy along with posing questions concerning the best way to use these techniques. Your feedback is welcome and appreciated.
Holding a diversified portfolio is a common risk management strategy. Diversification means different things to different people. Should one strive to hold investments over as many different asset classes as possible? Is diversification across many types of industries most important? What is the minimum number of different positions to hold in order for a portfolio to be sufficiently diversified? Is it possible to be too diversified?
In my portfolios, I hold a maximum of approximately 20 positions, with each position, in theory, having a 5% weighting in the portfolio. 20 positions seems to be a sweet spot for me. More than that number can make it difficult to track each holding in sufficient detail on an ongoing basis. A 5% weighting allows each holding to play a material role in the portfolio’s growth and value, while not playing such a large role as to take down the entire portfolio if the company’s situation quickly turns negative. I don’t pay as much attention as many investors to diversification across asset classes or across industries. For example, I tend to avoid investing in companies that are heavily influenced by commodity prices. I have no idea which way a given commodity price will head, so I feel that investing in those types of companies is a gamble as much as than anything else. I am more concerned with holding positions in companies that I feel will benefit from secular tailwinds, and that are good and getting better. This approach means that I will miss out on a large positive run in the price of gold or oil, but I can accept that opportunity cost in order to avoid the downside risk. My approach does mean that my portfolios are exposed to a potentially larger-than-market downturn. Holding a relatively large weighting of technology-driven companies could translate to outsized risk in the event of a general technology-driven crash, but I am willing to accept that risk in order to be invested in a large number of technology-based companies that should benefit from secular tailwinds.
Holding a portion of a portfolio in cash, or cash equivalents, can help to manage risk by limiting the portfolio’s overall exposure to negative market moves. A ready cash balance can also allow you to take advantage of decreased prices by adding to positions. Is it important to specify a particular percentage of the portfolio to be held in cash? What is an appropriate percentage? Is any cash held in a portfolio wasted capital, in that it is not earning anything and is in fact losing value in an inflationary setting? If that is the case, then perhaps it’s best to always be fully invested and to immediately invest any cash that is added to the portfolio.
I always tend to have a cash balance in my portfolios, but I don’t set a desired percentage. The cash balance in any of my portfolios is a result of yet to be invested contributions, yet to be reinvested dividends, and proceeds of sales. It’s important to have a cash balance in order to take advantage of any significant negative price movements. Buying additional shares of great companies when those shares are “on sale” is an excellent way to add alpha to a portfolio. As an example, having some cash available during the 2020 COVID-19 driven market decline allowed an investor to purchase additional shares of excellent companies at a deeply discounted price. When I add cash to a portfolio (eg.- an annual contribution to a retirement fund), I don’t feel obligated to invest that cash right away. I prefer to keep it in liquid form until a particular stock price reaches a level at which I am comfortable buying.
Buying In Chunks
Is it best to go “all in” on a position, or to plan to buy a smaller initial position, then add to it as time passes? Buying a full position can invite risk by fully exposing you to a sharp price drop, but will also allow you to take full advantage of a sharp price increase. Buying a smaller initial position then adding to it over time can dampen your exposure to large price decreases while allowing you take advantage of price declines by adding to your position at those lower prices. Buying in chunks can also allow you to add to your position as the share price rises as you become more confident in the company’s prospects.
I tend to buy my positions in chunks as opposed to buying the total positon right away. For example, I started a position in West Pharmaceutical Services (WST) in April 2020 at a price of $152.14 per share. But, that purchase represented only 30% of a full positon of WST for me. By purchasing less than a full position, I felt that I was limiting the downside risk that I would introduce by purchasing a full position, while allowing for future purchases at potentially better prices. I increased my position in WST to 60% of a full position in July 2020 at a price of $227.09 per share (after an earnings report that gave me more confidence in WST prospects). In October 2020, I made two separate WST purchases at an average share price of $281.43 (after share priced declines). Those purchases maintained my WST holding at 60% of a full position. Clearly, I’d have been best off buying that 60% position (or a full position) in April 2020 at $152.14 per share. But, by buying a lesser initial position, I allowed for the possibility of being able to increase my positon at lower prices, while limiting the risk of incurring a large loss had the share price sharply declined.
Using a stop loss, or selling a position if you have incurred an unrealized loss of a certain dollar amount or percentage, allows you to limit your risk of large losses than can materially decrease the value of your entire portfolio. The stop loss allows you to “get out of the way” of a rapidly declining share price. The use of a stop loss is most appropriate if you have bought a full positon right away, but can also be effectively employed if you have gradually increased your position by buying in chunks. A potential disadvantage of employing a stop loss is that you can exit a position, only to see that company’s share price quickly turn in a positive direction. You can miss out on a rewarding holding by limiting the short term risk of a large loss.
I have occasionally used stop losses in practice. For example, in July 2020, I purchased a full position in BioNTech SE (BNTX) at a share price of $89.79 in anticipation of its COVID-19 vaccine becoming widely accepted. I viewed this as a short term investment, so I was comfortable buying a full initial position. I placed an 8% stop loss on my position in order to avoid any potentially large loss. Just six days later, the share price had dropped to $82.33 (ie.- 8.3% below my initial price), and I sold the position. I was comfortable with the 8.3% loss on the short term investment, and I was happy to get out of the way of a price that would decline as low as $57.81 in early September 2020. However, the disadvantage that I noted above has also been illustrated, as the BNTX share price rose to a high of $129.54 in December 2020 as the vaccine was approved by many governments.
If you use stop losses as a risk management technique, what is an appropriate percentage to set?
Ratcheted Decision Points
Forcing yourself to make decisions regarding your positions can allow you to avoid the risk of inertia causing you to potentially miss out on opportunities to increase your holdings in a given company. The practice can also force you to recognize a material change in the company that may require you to exit the position, allowing you to avoid a potentially large loss. It is important to periodically revisit your investment theses and to act according to changes in your theses. That concept is fundamental to investing, but can fall by the wayside as time passes. Setting a specific price point at which to reassess your position forces you to periodically practice risk management on a company-specific basis.
For all of my holdings, I set ratcheted share price points, at which I force myself to either purchase shares, sell shares, or take no action. As a holding’s share price reaches a new high, I set a decision point at 90% of that price. For example, the share price of PayPal (PYPL) reached a new high of $237.72 on December 21, 2020. I set a decision point at a price of $213.95 (ie.- 90% of $237.72). On December 22, 2020, the PYPL share price hit a new high of $243.49. I set an updated decision point of $219.14 (ie.- 90% of $243.49). If the PYPL share price drops to $219.14 before it hits a new high and requires me to set an updated decision point, then I’ll make a decision (based on factors such as position size, valuation, and company news) to either buy shares, sell shares, or do nothing.
Once a share price has dropped 10% from a new high, I continue to set decision points in increments of 5%. For example, shares of Microsoft (MSFT) reached a high of $231.65 on September 2, 2020. At that point, I set a decision point of $208.49 (ie.- 90% of $231.65). The MSFT share price dropped below my decision point of $208.49 on September 8, 2020, at which point I evaluated, and added to, my position. I set a new decision point of $198.07 (ie.- 95% of $208.49) which has not been reached at the time of writing.
With a long term focus, I generally end up taking no action when a decision point is reached. I will sometimes decide to add to my position. I very rarely decide to sell any portion of a position at a given decision point.
Is it best to set a desired return when starting a position and to sell the position when that return has been reached? That strategy would allow you to realize a profit on the investment while avoiding the risk of the share price reversing and turning what would have been a profit into an unrealized loss position. Is it better to only sell part of a position at a certain point, allowing you to realize a profit while retaining exposure to future share price increases? Perhaps it’s best to only sell a position if the company’s story changes for the worse. That practice would allow you to fully participate in future share price appreciation, but introduces the risk of a materially large price decline having a significant negative impact on your entire portfolio.
I’ve struggled with the decision to sell. In the past, I have set a rule that required me to sell part of a position once that position reached a certain percentage of my portfolio’s total value. Specifically, once a position reached 6% of the portfolio’s total value, I was required to sell enough shares to decrease my position to 4% of the portfolio’s total value once the share price dropped by 5%. My reasoning was that I was happy to allow the positon to grow in relative size until the point that the share price dropped by a material amount. At that point, I’d lock in some profits on the position, maintain exposure to future share price increases, and be able to take advantage of further price declines by re-purchasing shares to reach a full position. For example, on May 25, 2020, Shopify (SHOP) shares closed at a new high of $1187.98. My SHOP position in one portfolio had climbed above 6% of the total portfolio value. I set a sell point of $1128.58 (ie.- 95% of $1187.98). If the SHOP share price dropped below that level, I would sell enough SHOP shares to decrease my position weight to 4%. The next day, the SHOP share price dropped below my sell point, and I executed the partial sale of my position. I did realize a healthy gain upon the sale, but the downside of the practice is evident when recognizing the fact that the SHOP share price has climbed significantly since May 2020. Although I did realize a good profit on the sale and I managed the risk of a quick price reversal eroding any future gains, the fact is that I would have benefitted by continuing to hold the full SHOP position. I am not currently practicing this sell discipline, and am considering changing my approach to only selling a position if the company’s story materially changes for the worse or if I feel I can replace the company in the portfolio with a superior investment.
Do you exercise a sell discipline? Did it take some time to become comfortable with your sell discipline?
Holding a portion of a portfolio in fixed income can provide a hedge against the risk of a general market share price decline. A portfolio that is 100% invested in equities could be expected to drop a full 30% in a general 30% equity market decline. A portfolio comprised of 70% equities and 30% fixed income may only see a drop of 21% in the event of a general 30% equity market decline. Is there a preferred level of fixed income investment in a given portfolio? Should that level differ based on factors such as the age of the investor, the overall beta of the equity investments in the portfolio, and the investor’s general level of preferred risk tolerance?
I’ve chosen to hold a relatively small fixed income position; 15% of the total value of one of my four portfolios. All other components of the four portfolios are comprised of cash and equities. I feel that choosing to invest in strong and improving companies that should continue to benefit from secular tailwinds outweighs the risk mitigation advantages of holding a significant relative weight of fixed income.
It’s often said that the best approach to investing is to avoid looking at your portfolio on a regular, short term basis (eg. - daily, weekly). I understand the reasoning behind that approach, and generally agree with it as it pertains to an individual who is paying a professional to manage their portfolio. However, for those who do choose to manage their own investments, regular monitoring of a portfolio is key to managing risk and allowing the portfolio to realize potentially index-crushing gains. Employing one or more of the strategies noted in this article will allow you to pay appropriate attention to your investments and to both mitigate risk and allow for excellent returns.
I look forward to your feedback related to any of these strategies. I’m curious to read about how you employ any of these techniques and am interested in any other risk management strategies that you practice. I am always interested in improving my risk management process. Any and all constructive criticism is appreciated.