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Buy and Hope versus Risk Management

Buy and Hope versus Risk Management

Regular readers of this space know that we believe in Exchange Traded Funds as an alternative to individual stocks and mutual funds because of their flexibility and diversification. However, as much as we like ETFs, they can lose value just like most other types of investments. The past few weeks have shown an increase in market volatility, mostly to the downside. While knowing what to buy for an investment is certainly important, knowing when and how to sell is the most important part of investing in our opinion.

The first thing to remember about selling is that there are two kinds of investors: those who sell too soon and those who sell too late. Trying to pick exact tops and bottoms of the markets is a futile exercise at best and potentially very costly at worst. Investors who sell too soon usually have made a profit and desire to lock in that profit. This isn't always a bad thing as most of us feel that profits are good. If an investment meets or exceeds our return goal, it might be a good idea to reposition at least a portion of the profits elsewhere. The flipside is that excessive trading can cost money and only generates short term capital gains which are taxed less favorably than long term gains. Still, a profit is a profit and that is good. Investors who sell too late employ the ?buy and hope? theory where they find themselves ?hoping? that things will turn around someday.

Generally, things do turn around, but a fortune can be lost while they wait.

Selling is the most difficult part of investing, but there is a tool that can help ? the stop-loss order. This is an order that you can give to your broker or enter in yourself that generates a sell order if your investment drops to a price that you determine. The risk of using stop orders is that the market sells off big in the morning, for example, you get sold out, then the market recovers. More often, though, an investment declines to its stop price and just keeps on falling. Remember, there is no law that says you can't buy something back at a lower price. An expansion of the stop order is a 'trailing stop? where an investor increases the stop price as the investment increases. By utilizing this strategy, the investment usually is sold with a profit when it does finally sell. This is our preferred method in most cases.

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