This article appeared in the February 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Practical suggestions to improve returns by managing market risk.
By Gary Stone, Share Wealth Systems
Here are my top educational trading tips for 2013 and beyond.
1. Have a big picture view - secular bull markets and secular bear markets
History shows that secular (or very long-term) market periods, bull and bear, last around 17 or 18 years but can last just 13 years or so. We are now in a secular bear market that has lasted nearly 13 years. Within secular bull and bear markets, primary bull and bear markets occur that present plenty of opportunity for longer-term investors, as well as active investors and traders, to take advantage of market rises and falls within the long-term trend.
(Editor's note: the term 'secular' refers to a long-term trend that can last at least five years and have short-term trends within it, which do not alter the long-term trend. For example, the sharemarket can have a strong year within the context of a bear market that takes years to play out).
2. Investing is risk management
Protect investment capital by deploying viable risk management strategies before getting dazzled by potential returns. Manage risk well and the returns will take care of themselves. This means ensuring the worst possible scenario is still good enough to meet minimum investing objectives.
A good mantra for investing is: "Plan for the worst but expect, or hope for, the best". Some key risk management strategies are suggested below.
3. Systematic risk (market risk) is the most important risk to manage
When overall sharemarket risk is high for shares, there are very few companies, if any -depending on what causes the systematic risk - that will rise or, even not fall, during a bear market.
There is a very low probability that internal company strength will mitigate the risk of the overall market falling, nor will portfolio diversification.
4. Understand volatility drag
Without getting into the mathematics, this is the drag on a portfolio that comes from falls. The deeper, longer and the more falls in the portfolio value (called drawdown), the more difficult it is for the portfolio to recover.
Investors underestimate the huge effect a bear market can have on their portfolio that will remain for the rest of its life. Minimising portfolio drawdown should be one of an investor's main priorities that would demand a strategy for handling systematic risk.
5. Understand and accept there are too many variables that cause risk for you to manage
There are thousands of variables operating outside internal company fundamentals that can cause the share price to fall. Trying to understand all of them is impossible, especially years in advance. But simple risk-management strategies can protect investors against variables when they can have a hugely negative effect on a portfolio.
6. Investing is not about predicting, but about reacting
Analysis to predict the best stocks to be in for the long term is time consuming and requires a lot of research to determine company strength. Each time an investment decision is made, the research process needs to be repeated. Even so, no amount of company research will mitigate systematic risk, or the risk of the overall market falling.
When your investing mindset changes to reacting and not having to correctly predict the long-term prospects of a business, there is no pressure to get the stock prediction right many years in advance. Such a mindset will use stock price action to determine the company's current prospects and react accordingly. Once such a strategy is devised, it can be repeated over and over again in minutes without the need to conduct time-consuming company research.
7. Avoid large loss positions
One or two large loss positions in a portfolio can decimate it for years and some may never recover. Think of portfolios that contained one, two or three listed property trusts among its positions. Australian real estate investment trusts (A-REITs) such as Centro, Stockland or GPT were favourites through the 1990s and into the 2000s. What about other darlings such as ABC Learning, HIH Insurance, One Tel, or Babcock and Brown?
Not all stocks return to their former glory prices. The only way to avoid such occurrences in a portfolio is to have a well-defined and timely last-resort exit strategy. Investors are not constrained by lack of choice, but most do not include a last-resort exit, believing that company fundamentals or a "story" about the stock will revive its fortunes. No one knows all the variables that interact on a business, nor do they know what the future will bring.
8. Buying more of a falling stock is NOT good idea
If there is one certainty in life it is that things change. When a stock falls while its fundamentals are still good, there is no guarantee its fundamentals will remain solid in the future.
The only reason you might continue investing in a falling stock price is, for whatever reason, fundamental or psychological, you are banking on the price making a comeback. That is a gamble.
9. Establish a rigorous investing process
To put all the investing tips discussed in place, every investor should create a personal investing plan - think of it as your Business Plan for Investing. All of the above should be handled by well-thought-out processes and be documented accordingly.
About the author
Gary Stone is founder of Share Wealth Systems, a leading provider of sharemarket trading systems. Read his free report to discover the financial principles and critical information for you to be successful in the market. You will learn tried and tested processes that have been rigorously researched.
Or visit Share Wealth Systems for a free copy of The Trading Manifesto by Gary Stone.
ASX Charting Library provides a wealth of free material for beginners through to advanced chartists.
The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
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