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Stops are a Simple Way to Manage Risk & Emotions

|Includes: SPDR S&P 500 Trust ETF (SPY)

The market remains in an uptrend short term off the August lows. The run is getting extended technically and there are plenty of arguments from analysts on the trend extending to the April highs and a correction back to the 1040 lows on the S&P 500. From my perspective you never fight the trend, but you do have to manage risk. Thus, I thought we would revisit one of my favorite topics.

After more than 28 years of investing personally and professionally, I am of the opinion that risk management is single handed the most important component of the investment process. Most investors learn about market risk the hard way – they lose money. If we take the time to learn how to manage risk relative to each position in our portfolio we will be far ahead of the game.

What is risk management? It is the process of managing the risk of money in relationship to the market. Simply put – it is money management. When money management is discussed risk is one of the many elements addressed. From my perspective it is the embodiment of money management, the foundation on which you build a portfolio of stock, bonds and other investments and the process by which it is managed until the asset is sold. Taking on too much risk by position or portfolio is the downfall of many investors.

For this example we will use SPY, SPDRs S&P 500 Index ETF. This fund corresponds to the index and in fact is invested in all the stocks in the index. The fund trades intraday like a stock under the symbol SPY. Thus, your risk of owning SPY is equivalent to owning the index itself. If you put money to work in this fund how would you manage the risk? The simplest way is STOPS.

It is amazing how many investors do not use stops to protect against the downside risk of the market. As many of you are aware, a stop is nothing more than a standing order to sell, in this case SPY, if it falls below a specific price. Why would you want to have this order in place? Take a moment and think about what emotions you go through when the stock market is declining in value. Anxiety? Fear? Panic? They may all over time to describe the feeling you experience during a correction. Thus, the reason for using stops; taking emotions out of the equation or decision process.

Two things come to mind relative to losing money. First, disgust and depression as no one likes to lose money. Second, psychological brain damage as many will dwell on the loss. Here in lies the challenge for most investors; getting over the damage done from losing money. This is where having a defined strategy for managing the process of investing is important. Part of that strategy is a defined stop on every position within your portfolio. The stop is determined at the point of purchase based on the strategy first and on the amount of money you are willing to risk second. Thus, a stop allows you to take the unknown and make it known. Defining your loss prior to starting will give you clarity and focus to each position and remove some or all of the emotions at the defined exit point.

We have heard the saying, ‘let your profits run and cut your losses’.  Stops put in place are a method or strategy to allow you to let your profits run as you ladder your stop up as the price rises. In the same way it cuts the losses on your losers and keeps you from holding them too long on the way down. Stops are a great risk management tool and one well worth time to learn how to use. The chart below is an example of how to manage your stops on a position letting the profit run until which time the stop is hit. Invest the time to learn how to use stops.

There are plenty of other methods you can learn to hedge or manage risk in your portfolio. Start simple and expand your knowledge as you manage your money.

Disclosure Statement: Jim Farrish is the Founder and Editor of SectorExchange.com and TheETFexchange.com as well as the CEO of Money Strategies, Inc., a Registered Investment Adviser with the SEC. The company and/or its clients may hold positions in the ETFs, mutual funds and/or index funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. Investors who are interested in money management services may visit the Money Strategies, Inc., web site.


Disclosure: no positions