Two of the most important skills for long term investment success are capital allocation and risk management.
Capital allocation tends to get most of the attention in the press, which publishes headlines like “Where To Put Your Money Now”, or “10 Hot Stocks To Watch”, or perhaps a list of recently funded startups. This is especially true when markets are good and everything is going up.
Risk management isn’t nearly as interesting to the average person. It’s much more interesting to hear about the 800% return in titanium stocks over the past year than the possibility of losing money.
The past couple of weeks have reacquainted investors with market risk. For new investors who haven’t seen a down market in action, this is especially painful. The Indian stock market has been popular with emerging market investors in the US, as well as in India. It had been up around 50% since the beginning of the year but dropped 10% in a single session, and around 30% in a few days last week, triggering margin calls and placing police on suicide watch. The decline in US markets has been tame by comparison.
This afternoon the Enron trial came to an end, with Jeff Skilling and Ken Lay found guilty of fraud, conspiracy, and other charges in the collapse of what was once a $68 billion dollar company.
Barry Ritholtz used Enron’s declining share price to illustrate the importance of risk management and sell stops a few weeks ago:
It wouldn’t have prevented you from losing money, but it would have kept you solvent. The buy-and-hold employee and retiree shareholders probably weren’t so lucky.
I recently became aware of a risk I hadn’t thought of in a while - platform risk. Yesterday I had a profitable short term trade locked in with a protective stop which failed to trigger when the share price turned and passed through the stop level. I asked Schwab to investigate, and it turns out they may be having intermittent problems with certain trailing stops entered through the trading window rather than the custom alerts window in Streetsmart Pro, their client application. They adjusted my trade to reflect the correct stop value, which was logged on their server but not executed.
Trading with unreliable stops in the current market is like driving a car with brakes that don’t always work. I appreciate Schwab making good on the trades, but I hadn’t considered the possibility of correctly entered stops not being executed when hit before yesterday. Kind of like people hadn’t considered the possibility of widespread fraud at Enron before it blew up.
Asset allocation is important, but risk management can keep you in the game when the unexpected inevitably happens.
