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I have a tendency to wear my mind on my sleeve
I have a history of losing my shirt

--Barenaked Ladies

UMV 142: Risk Management II: Controlling Losses (Updated 03/08/2007 02:09:24 PM )

Introduction

In a separate discussion, we examined managing risk through diversification.  Here, we'll look at some ways for actively controlling losses.

Defining Risk and Controlling Losses

Stops.  Sometimes, traders use 'stops' to manage risk.  For example, a while back Todd Harrison entered a bullish stock market trade and placed a stop at 1175 on the S&P 500 (SPX).  A stop is a price level that will cause you to exit your position.  

Chart courtesy of StockCharts.com  

Why do such a thing?  After all, any drop in price might be temporary.  But it might not be.  So this is about risk management--reducing your potential for loss.  Left to their own devices, individuals are usually reluctant to exit losing positions (Odean, 1998).  Stops remove emotion from the process and help maintain discipline to cut losses while they're small.  For Todd, stops help him stay true to one of his cardinal rules: Never define an investment as a trade that has gone awry.

Think twice about adding to a losing position.  Seasoned veterans know that emotion is the enemy when participating in financial markets--which is one reason why successful investing is so difficult.  One mistake that many market participants make is to 'average down' when a position goes against them (Kahneman & Tversky, 1979).  When driven by emotion, this process often results in taking excessive risk--instead of cutting losses in a losing situation.  Managing a losing position is of the most difficult financial decision making skills to learn, and one that is highly correlated to success (Schwager, 1989).  

A noteworthy example of how to manage a losing position occurred when Minyanville professor John Succo's firm initiated a position in Refco, a securities clearing house that made headlines due to allegations of managerial and accounting fraud and the potential of this situation to disrupt markets.  After the position moved against him, John resisted the temptation to add to his losing position and, instead, moved on to the next trade.  

Small bets.  Assume you have $100,000 to invest.  You're considering two possible ways to allocate these funds.  Possibility I consists of splitting your capital into two $50,000 portions.  One of these portions would be invested in the stock of a risky, although potential profitable start-up venture involved in developing alternative energy sources.  Possibility II consists of splitting your capital into fifty $2000 portions, with one of these portions allocated to the risky alternative energy venture.  

Let's suppose that the worst case scenario happens to the alternative energy company.  The venture goes bust and the stock's value goes to zero.  How would this affect your portfolio?

Table 1: Comparison of Losses Assuming $100,000 Initial Investment Portfolio

  Possibility I Possibility II
Asset allocation in portfolio Two $50,000 portions Fifty $2,000 portions
Allotment to alternative energy company stock $50,000 $2,000
Value of portfolio if fuel stock goes to zero $50,000 $98,000
% of original investment that is lost 50% 2%

As shown in Table 1, the impact of a bad investment on Possibility I is considerable.  Fifty percent of the original $100,000 investment is lost.  The impact on Possibility II is much less severe, as only 2% of the portfolio's initial value is lost.  

The message: smaller bets reduce the risk of losing big on any single position.  This brings us full circle to the general notion of diversification (Markowitz, 1952) discussed previously.

Final Comment

One assumption baked into the above strategies is that you are an informed market participant when initiating risk.  Of course, this is not always a good assumption.  Indeed, many folks spend more time researching their next refrigerator purchase than they do studying prospective financial assets.  Developing solid financial market awareness will make you more capable of dealing with the "How much can I lose?" question that is central to risk management.

References

Kahneman, D. & Tversky, A. (1979). An analysis of decision under risk. Econometrica, 47: 263-292.

Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7: 77-91.

Odean, T. (1998). Are investors reluctant to realize their losses? Journal of Finance, 53: 1775-1798.

Schwager, J.D. (1989). Market wizards. New York: Harper Collins.

Quick Quiz...

142.1) Steve never lets a position in his portfolio lose more than 20% before selling it.  It is apparent that Steve uses ____ when managing his portfolio.

  1. advice
  2. hedging
  3. stops
  4. stochastics

142.2) Adding to a losing position is usually the best way to recover lost capital.

  1. true
  2. false

142.3) All of the following are good approaches for defining risk EXCEPT:

  1. Setting stops
  2. Concentrating a portfolio in a single asset 
  3. Betting small
  4. Cutting your losses

142.4) Risk management focuses on minimizing losses rather than maximizing gains.

  1. true
  2. false 

 

Answers: 142.1) c 142.2) b 142.3) b 142.4) a

 

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