To date, 2011 has been a roller coaster year for investors. The market started out strong as the S&P 500 climbed 6.87% to a high of 1344.07 by Feb. 18. This quickly was given back as stocks retraced their steps over the next four weeks. Fast forward a few months, and we were within reach of setting fresh highs for the year, that the market eventually did make in May.
For casual and active investors alike, this is hardly an ideal situation. For the last four months of 2010 the S&P 500 rose a staggering 19.85% with little drawdown. The lack of consistency seen so far in 2011 challenges the recent bullish mentality and presents investment uncertainty.
The best way to combat this uncertainty is by lowering risk through simple portfolio modifications and strategies that can give you a better chance at success. Here are six tips, in two broad categories, for investing more effectively in volatile markets.
What many investors fail to acknowledge is that cash is an actual position. For the pundits who say that cash represents a waste of the time value of money because it doesn’t generate returns, ask them how their 100% long portfolio fared in 2008. Any cash portfolio easily outperformed the market averages during this time.
There is a lot to be said for sitting on the sidelines and going to bed at night knowing your portfolio is safe. And some online stock brokers offer high-yield savings for long-term cash positions that can serve as an extra boost to your bottom line.
For our purposes we are focusing on equities, but a balanced portfolio also should include alternatives. While cash often is the best alternative in volatile equity markets, a cash holding entails its own risk. In highly inflationary periods, cash can be a net-loser.
1) Match cash to confidence: Every investor has his or her own comfort level of what percentage of an investment portfolio should be sitting in cash at any given moment. For those investors who have a tough time managing their cash allocation, one easy way to determine your threshold is to consider the following question: "Do I feel confident that the market is going to rise over the coming month?" Give the answer a score of one through five with one being no confidence and five being extremely confident.
The lower your confidence, the lower your net exposure to the market should be. If it is a one, then a 80%-100% cash position is best. If a two, then 60%-80% is more suitable, and so on until you’re 100% vested in the market with no cash on the sidelines. For investors who are less active, this exercise could be conducted once a quarter or less frequently. Every independent investor should rely on one person, themselves, in making investment decisions. This exercise, while simple, reinforces self-dependence.
2) Unwind right: To achieve your desired cash level, start by converting any margin positions to fully funded and selling losing or laggard positions. Losing stocks are a drain on the portfolio. They not only affect your mental psyche (no one likes logging in day after day and seeing red), but also are more at risk for further declines if the market should struggle. By holding onto the absolute best positions both fundamentally and technically, you give your portfolio the best risk-to-reward moving forward. For the investor predominantly trading equities, this is as easy as placing several market or limit orders.
3) Manage your winners: If you have sold your losing positions and still are not at a desired cash level, trimming exposure in winning stocks is the next course of action. Arguably, the toughest decision any investor ever will make is deciding when to sell shares of a profitable investment. It is never an easy call. So, instead of completely selling off one or more of your top holdings, try liquidating 25%-50% of several winners and converting those unrealized gains to locked-in profits. This way, you still maintain a broader exposure with your best stocks while accomplishing the task of raising cash for your portfolio.
With your portfolio’s exposure to the market aligned with your current confidence, you can zero in on managing your freshly trimmed portfolio by adding extra protection against the downside using stops.
4) Limit losses with stops: Stop-loss orders can serve as great protection against the downside when used properly. They remove the psychological battle of deciding on the right time to sell and help maintain a disciplined approach to the market.
A stop-loss order is like taking an insurance policy out against your position. If an investor holds 100 shares of company XYZ at $100 per share and they don’t want to lose more than 10% of their investment, they can place a stop with a trigger price of $90. This will automatically sell their shares if XYZ falls below $90 (10% of $100) at any time in the future.
The only event that can prevent their stop order from limiting their loss as intended is if the stock trades through their trigger price with a gap move. For example, if stock XYZ reports earnings and falls to $85 in after-hours trading, the stop order would not have triggered at $90, and the investor would be forced to sell their shares on the open market the next day. Traders always should work slippage into their calculations when setting stop levels.
5) Tighten stops in risky markets: Stops are particularly useful in tough markets because false breakouts and reversals are common. For traders who like to buy stocks on breakouts, setting a tighter stop of 3%-5% vs. the traditional 6%-8% can minimize losses. Take, for example, Google (GOOG), which had a short-lived breakout in January of this year (see "Short-lived gains," below). After basing out over a two-month period, Google made a push to fresh three-year highs above $631. Unfortunately, two of the next three days were heavy distribution days, and the stock collapsed back into its base.
False breakouts like this are extremely common in downtrending markets and prevalent in sideways markets where bulls and bears fight over future direction. In a smoothly uptrending market, it’s fine to employ looser stops, but when navigating uncertain markets, tighter stops can keep a portfolio afloat and moving forward.
6) Ride winners: Once a winner is found, trailing stops can maximize upside potential while ensuring profits are locked in as the stock appreciates. Trailing stops adjust the exit price on the fly by keeping a percentage or set value separation between the stock’s trending high from time of purchase moving forward. Referring back to the fictitious XYZ stock at $100, a 10% trailing stop would be set at $90 and move up along with the stock. If the stock hits a high of $120 the following month, the stop automatically adjusts to $108. The trigger price cannot fall in value, only increase.
A great example of how a trailing stop loss can be successful was seen with the run in Chipotle (CMG) late in 2010 (see "Maximizing profits"). Chipotle broke out of a two-and-a-half month base with a buy point of $155.50 on Sept. 1, 2010, and ran to a high of $262.78 over the next three months. It took out a high that went back to December 2007, making it a very strong signal. An 8% trailing stop would have allowed the investor to capture nearly the full move before getting stopped out just above $241 on Dec. 3. The trailing stop allowed the investor to limit exposure while maintaining his opportunity. Trailing stops promote a disciplined approach to managing winning positions. A weighted 100-day moving average also could be used and shows the progress.
Through the first half of 2008, utilizing the exact strategies mentioned above, an active equity portfolio was getting sold off constantly for small losses as breakouts failed and short-term winners reversed. While this portfolio was outperforming the market by minimizing losses and maintaining a strong cash position, it became apparent that the market atmosphere was not conducive for trading on momentum and buying breakouts. So, in August 2008, the portfolio was re-assessed and moved completely to cash. This was an excellent investment decision as the major indexes continued to struggle and October 2008, as all investors know, made history with its major declines.
Investing in a uncertain market does not have to be a stressful and difficult task. By remaining disciplined, trusting your own decisions and lowering risk with some simple portfolio tweaks, you can keep control of your account and invest successfully with confidence.
Blain Reinkensmeyer is an independent investor and co-founder of StockBrokers.com. He provides stock market education at StockTradingToGo.com and market recaps at TraderMike.net. Email him at firstname.lastname@example.org.