How to protect yourself from market losses?

Question: The value of most of the stocks I bought a few weeks ago has gone down. The market has been quite volatile lately and I don’t know if I should hold on to my stocks or buy more to average down or just simply sell them now and trade anew. I know that I need to diversify but I can’t seem to manage my investment allocation and losses. Can you help me?–Badet M by e-mail

Answer: Every investor in the stock market is going to lose money at some point. No matter how good you are in predicting market direction or picking the right stock, chances are, you will make the wrong calls on some stocks and start to struggle with losing trades.

The risk of losing is an inherent part of investing. It is a risk that you cannot totally avoid even if you have the best trading system in the world. As an investor, your aim is to protect your capital at all costs by minimizing your risk. You cannot afford your capital to lose so much that it reduces your capability to achieve your earnings objective.

How do you minimize your risk of losing? Conventional wisdom will tell you that you can do this by diversification. When you diversify, you are able to manage the risks that may directly affect certain stocks or industry where the stock belongs to in your portfolio.

In theory, when your stocks are down, your other stocks in the portfolio can rise up to the occasion and offset all the potential losses, thereby keeping your capital intact at the very least.

So how do you really diversify? How many stocks should you invest in order to diversify? How much should you invest in each stock? How much paper loss can you tolerate in your portfolio?

One strategy that you can apply for diversification is the use of position sizing. Normally, when you invest in a stock of your choice, you randomly invest the number of shares. The more bullish you are on the stock, the higher the amount of your investment. Of course, you need to diversify, so whatever is left in your capital, you will invest in your less preferred stocks and make it part of your portfolio.

What normally happens is when you make the wrong bet, your losses will be huge and can even wipe out all the profits made by your other investments in the portfolio. This can happen because the risk that you assumed was arbitrarily based on your emotions.

In position sizing, you will base your investment on the amount of risk that you are willing to take. For example, your total capital for stock investment is P1 million. You need to decide the amount of loss that you are willing to accept per investment. For this purpose, assume that it is equivalent to 1 percent of your capital, which translates to P10,000.

Now let’s say that you plan to invest in Ayala Land (ALI) at P41.10 as your first trade. To determine how many shares you need to buy, you must first determine your stop loss price, meaning if the stock falls at that price, you need to cut your losses by selling it. In this example, assume that you set it at 8 percent maximum loss. This means that the maximum loss that you can take from ALI at 8 percent below your purchase price will be P3.30 per share.

To compute for the number of ALI shares that you need to buy, simply divide the amount of capital loss of P10,000 by the amount of risk per share or P3.30, which gives you 3,030 shares. Since the board lot of ALI is 100 shares, you can round it off to 3,000. At 3,000 shares, your maximum investment for ALI is P123,300.

From here, you can move on to other stocks following the same rules with 1 percent of capital per trade at 8 percent stop loss target. Let’s say you chose Meralco (MER) as your second stock in the portfolio. Assume that you will buy the stock at P274 so your stop loss price will be P252, which will give you a risk per share of P22. Following the same process, divide again the P10,000 with P22 per share and you will get 454 shares of MER that you need to buy. You will see that when you multiply 454 with the purchase price, you will get a total investment of P124,396, roughly about the same amount with ALI.

You can move on by adding other stocks into your portfolio following the same rules. You will observe that it will approximate to a total of eight stocks.

Of course, you can choose to change the rules. Say, you can be more aggressive with higher capital loss of 2 percent to 3 percent. At this rate, the number of stocks in your portfolio will be lower as the amount of investment per stock increases. In the same way, you can also change the stop loss percentage though 8 percent is the recommended cut loss.

Why 8 percent? If you lose 8 percent, the amount of gain that you need to recover is only 8.6 percent, about the same percentage of your loss. Higher stop loss will mean higher percentage to recover. Imagine if you lose 50 percent, you need to gain 100 percent to recover, which can be difficult.

Using position sizing as a tool in your diversification strategy can help you manage your risks by cutting your losses short while letting your profits run. It doesn’t matter if you lose some trade for as long as you are able to control it. You can always recover with your other stocks in the portfolio which can win big time for you.

Henry Ong is Registered Financial Planner of RFP Philippines. To learn about value investing in stock market, attend the globally recognized Accredited Financial Analyst program on June 20 to July 25. For more details, inquire at [email protected] or text <name><email><AFA> at 0917-3464126.