To recover from a stock that goes down by 50 percent, it will need to go up by 100 percent. The chances of this happening in the short term are very slim.
Moreover, suffering from a 50-percent loss is emotionally stressful. This is why risk management is a very important skill that everyone who invests in the stock market needs to learn.
One of the most important ways to manage risk is to limit the size of your investment in the stock market. Although buying stocks is necessary to enhance the return of the investment portfolio, the amount you should invest is dependent on several factors such as age and income requirements. For example, if you are young and single, you can set aside a larger portion of your salary as stock investments because your earning capacity is still very good given the amount of time you can work before you retire. This puts you in an excellent position to sit through difficult times such as bear markets and to recover from any possible investment mistakes.
In fact, if you have children who get money as presents during their birthdays or Christmases, you should place almost the entire amount in the stock market since they have no obligations anyway.
On the other hand, if you are already close to retirement, you will soon need the income from your investment portfolio to support your day-to-day needs. As such, it is wise to have more fixed-income investments like bonds that provide steady returns to minimize the volatility of your portfolio.
Also, don’t invest funds that you know you will need in the short term such as the lump sum payment on a house that you bought on installment or your children’s college tuition.
Although stocks provide the best returns over the long term, they are very volatile in the short term. The timing of returns is also not guaranteed. You wouldn’t want to be forced to sell your stocks in the middle of a bear market when prices are depressed.
Another way to manage risk is by diversification or owning numerous stocks. As mentioned in my previous column, diversification protects investors from unforeseen incidents that could happen even to the best-managed companies, leading to the significant drop in their share prices. An easy way to achieve diversification is by buying an equity index fund. This allows you to have exposure to all 30 stocks that are part of the Philippine Stock Exchange index even with just a small amount of capital.
For active investors or traders, you should always have a reason for buying any stock. That way, if the reason for buying the stock is wrong or no longer exists, you have a good reason to sell. If you are a fundamentalist, which means that you buy stocks based on companies’ earnings prospects and valuations, you should sell your stock if new developments point to weaker earnings outlook or if prices have gone up to levels that are no longer fundamentally justifiable. If you are a technician, which means that you buy stocks based on technical indicators, you should enter every trade with a planned cut loss level and sell your stocks without hesitation when they hit those levels.
Never buy a stock just because of rumors or tips. Try to validate these tips, but if you can’t, at least have a plan on when to sell or cut losses if prices do not go up. Otherwise, your short-term trade could turn into a long-term investment that could become worthless.
With risk management comes less volatility. Hopefully, this will also mean better returns for your investment portfolio. At the very least, it should make investing less stressful, encouraging you to stay invested for the long term.
April Lynn Tan, CFA, is the chief equity strategist of COL Financial, the Philippines’ leading online stockbroker. She has over 20 years of experience covering the Philippine stock market. She heads the COL research team. For her market insights, follow @AprilLeeTan and @colfinancial on Twitter. For comments and suggestions, e-mail intelligentinvesting@colfinancial.com.