This weekend we have a nice friendly reminder about the importance of risk management. The way I look at it, it shouldn’t even matter what your strategy is as far as how to pick a stock or put on a position. The important question to ask is, “Where am I wrong?”. In other words, worry less about things you have zero control over – in most cases, “How high can the stock go”. And worry more about the only thing that we can control, “How much am I willing to risk for that upside potential?”. So think about it, if the only thing that we can control in our portfolios is the risk, and everything else is up to the market, why should we worry about anything else?
I realize this is extreme. And I put it this way on purpose so that we can think more in those terms. W. Scott O’Neil wrote this letter on his site and I had to post some of it because I think this is such an important topic. Scott is the President of MarketSmith and portfolio manager with the O’Neil companies. His post on drawdowns and risk managements is dead-on:
“Too many investors approach the market with only one thought in mind: “I want to make money.” Frankly, that’s never the proper approach to something as risky as the stock market. But in a downtrend, it’s even worse, as the probability of making money is greatly diminished. One of the more common mistakes investors make is to buy or hold onto stocks during a downtrend. Whether out of pride, hope or paralysis of fear, most investors seem to dismiss the signs of a changing market trend.
The key to surviving a downtrend is to minimize your portfolio drawdowns by staying out of the market until the environment improves. You never know how far down the market will go before it bottoms, and you can’t assume your stocks will escape unharmed. Remember, a falling tide lowers all boats. It doesn’t matter how good the fundamentals are, or how compelling the story is. We would rather risk getting out a little too soon versus taking a severe hit to our portfolio. Remember, when a portfolio is down 33%, it takes a 50% gain just to get even.
Defense should always be the number one priority over making money, which means that your capital preservation strategy must be in place PRIOR to investing in ANY stocks. Following this “defense first” strategy has helped our shop immensely, especially in the bear markets of 3/2000-3/2003 and 2008. People often ask me, “How did your shop know that 2008 was going to be so bad?” We didn’t! But what we did know in November 2007 was that the market was starting a new downtrend.
We will never argue with a market that is clearly signaling the beginning of a new downtrend. This straight-forward analysis can only be done on a stock chart. A stock chart of the major indexes gives the investor the proper perspective on what the stock market is actually doing at the time as opposed to opinions of what the market “should” be doing. In addition to monitoring the indices, any investor that does not consult a stock chart prior to buying a stock is severely disadvantaged.”