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3 Tenets of Successful Risk Management

During long uptrends in the stock market, most advisors rarely concern themselves with what their exit strategy would be if things do not go as planned.  At Fabian Capital Management, we find ourselves on looking deeper into our client's holdings to evaluate and prognosticate any potential weaknesses. Stock market investors should be concerned with the preservation of their gains, and prudence suggests making changes when volatility is low and liquidity is abundant. With so many market participants "Whistling Dixie" during a bull market environment, we hold firm to the belief that hope is not a viable investment strategy.

A fundamental tenet of our firm is that risk within any investment should be identified and planned for well in advance of any purchases. It's this type of strategic planning that will segue into successful changes to your portfolio as part of our active management philosophy. Once you understand the risks, the next step is developing a plan of action just in case the market turns against you.  The strategies below outline the tools we employ to protect our client’s capital.

Stop Losses

I liken this option to a familiar feeling almost everyone has felt - purchasing a car. When you push back from the negotiation table and shake the salesman's hand, in the back of your mind something is bothering you. It's that feeling that you could have done better, but also the reassurance that you also could have done a lot worse. That's the way we feel about stop losses, they are there to avoid the proverbial "big loss", and as an active manager we employ this type of strategy for every position within our client's portfolios as a cut bait point to stop the bleeding.

However, setting stop losses isn't as simple as it might seem.  It is truly an art form.  A stop loss should not be a mere price or percentage below your cost, but a dynamic strategy that can change with market conditions.  When formulating a game plan to set a stop loss, we always examine and apply technical analysis based on the price chart. This enables us to objectively monitor each holding on a daily basis and apply our sell discipline when needed. 

Selling for the Safety of Cash

My grandfather used to say that “lost opportunity is a much better feeling than lost money”. In real world practice however, they can both feel like the great equalizer. This brings me to the second tenet we have written on the wall at Fabian Capital Management; selling for the safety of cash.

In today's zero interest rate, ever inflationary world, cash is the most consistently underrated and chastised of all risk management tools. This mere fact makes cash a favorite of ours that we don't foresee changing anytime soon.

Developing our strategy for cash includes a couple of different perspectives, or ways of looking at our client’s portfolio goals and objectives. For example, the simplest of all would be evaluating a price target for a position, and then simply reducing the holding for the safety of cash once the target was met. That way, we are selling on our own terms, not when the market decides to force our hand.

Another example could include expanding our cash positions when we meet a predetermined growth or income goal in a single year, or even single quarter, as to simply reduce the future risk of drawdown. The size, length of ownership, and plan for cash should all be taken into account when making this decision. In the past, we have even gone so far as to set stop losses for our client’s cash positions, where they would "stop in" to a given market after having to large, or too long a presence there.

Hedging Equity Exposure

This often complex strategy involves teaming investment holdings together that have an opposite effect on each other in an effort to net out or mitigate a negative outcome. For a typical portfolio that has a large amount of equity exposure, an example might include adding an inverse equity fund, or pairing high quality fixed-income positions to offset the volatility. The pros to this type of strategy is that if timed correctly, we can recapture some or all of the unrealized drawdown by selling the hedge once it's reached a point where we are comfortable returning to our net long position. Another benefit would be that it allows us to keep highly appreciated positions in force without generating costly capital gains.

The crux of purchasing another holding, even if it's a hedge, is that you now have to manage the inherent risk in that position as well. We have witnessed it countless times in individual investor’s portfolios, where a hedge is "bought and held” with every intention to sell it at a gain, or after their hypothesis becomes reality, but their timing and discipline goes by the wayside. As nervousness and anxiety sets in, the investor ends up selling the hedge at a large loss, then curses the day they purchased it. The psychology of investing can play tricks on all of us at times, but in our opinion it takes a trained mind to maintain the discipline and vigilance needed to execute a strategy like this successfully. At Fabian Capital Management, we only implement hedges in very specialized situations and monitor them daily.

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Comment   |  6 years, 7 months ago from Irvine, CA