If you follow my posts at all you know that the primary theme is risk management. If you don't manage the risk of each position in your portfolio the downside can always be greater than you expect. Which reminds to state clearly that there is a distinct difference between volatility and risk. The study of volatility permits you to understand the day-to-day movement of a specific stock or asset class. Risk is the study of probability of loss. Not measuring volatility correctly will result in getting stopped out of positions sooner than you wanted only to see the position go up from there. Risk is potential loss of money, plain and simple. I like to start any explanation of money management with the difference between volatility and risk. Understanding, planning and investing with both in mind will make you a better investor over time.
The three steps we must follow when putting money in the market are, where do we get in, where do we get out, and where are we going? If you are putting money to work without a working knowledge of those three events prior to buying, you are running money without clarity. In an up trending market you will find the harm may be less than a sideways or volatile market environment, but eventually the loss may be catastrophic. The goal is to have a defined objective prior to putting your money at risk.
The first step, Entry (where to get in). Unfortunately investors spend more time on this than anything else. I find the entry process to be the easier of the three steps, but some will labor endlessly over what to buy and when to buy it. We will scan and scan looking for what we think is the perfect investment, only to discover it didn't quite work out that way. Define what you are looking for that fits or relates to the current market environment. That can be volatility, trend, momentum, etc. Scan for what fits, then defines what entry point works relative to risk tolerance on the downside. Momentum plays are different than dividend plays. Know the parameters you want and then define your entry price in light of the risk and volatility.
The second step, Exit (where to get out). It is better to know where the exits are prior to an emergency than attempting to find it when the crisis is on. Remember, planning when you can think logically versus emotionally is the key to success. If you enter a position at $20 and you define your stop or exit at $19, you know what the worst case scenario is for your money. That makes the entry easier, and the emotions manageable when the market turns against you. A loss is still a loss, but you already knew what the worst case was before you bought the position. Remember that emotions are one of the biggest obstacles to investment success. The second component of the exit is stop management or profit management. Adjusting your stop higher as the position gains in value is just as important as the entry or original determination of the where to place the stop. Spend time working and developing a strategy that fits your risk profile.
The third step, Target (where are you going). Again this is part of the strategy or risk management determination. Learning to set realistic targets that give appropriate risk management measures is key for successful investors. I have always looked at the upside profit versus the downside risk as an key measure of the position management. This goes hand in hand with size of the position. This is where looking at percent versus dollars makes the point better. If you are going to buy XYZ stock at $30 per share with a stop at $29 (loss of 3.4%) and target of $32 (profit of 6.7%). OR, with 1000 shares you will make $2000 or lose $1000. I have come to the realization that I spend money not percent of return. Thus, manage your target the same way. Once you obtain the target, like with a stop, you have to manage the process of taking profit. It important to mention here that greed is a larger emotion to manage than fear, but both cause procrastination.
We will discussed all three steps in detail on our recent webinar: Entry, Exit & Target