Last week, we received an extremely poignant reader question. And it cuts to the very basics of investing in a situation like we have today.
"How do I manage risk without missing out on opportunity?"
On its surface, the question is a bit of a paradox. By definition, one must take a risk to make money in the market. But the more that I thought about it, the more this question centers around the right way to manage your portfolio in today's tricky economic environment.
I have frequently said that the market is not the economy, and the economy is not the market.
At Money Morning, we are continually thinking about how to reduce the downside of the market without significantly risking your principal.
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So, today, I'm going to discuss three common strategies that will help you manage your risk while still presenting plenty of room for profits...
Risk Management Strategy No. 3: Dollar-Cost Averaging
"Dollar-cost averaging" is the process of buying a stock at a fixed dollar amount regardless of the share price. This is a brilliant tactic to use in a period of economic uncertainty because it prevents you from being exposed to a price on a single day.
Let's look at an example.
Imagine that a stock - we'll call it company ABC - is trading at $25 per share today, and you want to invest $2,500. If you spent all of your money today, you could buy 100 shares.
But if you use dollar-cost averaging, you could send $500 per month toward shares of ABC.
In the first month, your $500 allows you to buy 20 shares at $25 per share.
Now, let's imagine that in late May, the economy has struggled, and shares of ABC have fallen to $20 per share.
Well, you would send your $500 to purchase the stock at this price, and you'd secure 25 shares.
The following month, the economy has rebounded a little, and shares now trade at $23.80.
$500 ÷ $23.80 = 21 shares
In July, it trades at $25 again. You automatically devote another $500 and purchase 20 shares:
$500 ÷ $25 = 20 shares
By August, let's say the stock rallies to $27.78 per share. You automatically pick up another 18 shares:
$500 ÷ $27.78 = 18 shares
Over five months, you've purchased 104 shares at an average price of $24.03.
A reminder, if you'd have purchased them on day one, you'd have bought all of your shares at $25 per share.
In this case, your total investment is worth 4% more because you used dollar-cost averaging.
If you use this process over your investing lifetime, you can significantly minimize your risk when it comes to market pullbacks. And you'll be continually accumulating shares of strong companies with major upside.
Risk Management Strategy No. 2: Trailing Stops
When you're investing and enjoying a nice run on your positions, you must protect your profits and your principal. That is why we recommend trailing stops.
By definition, a trailing stop adjusts a stop-loss that rises as your stock price rises.
So, let's suppose that you buy shares of Alphabet Inc. (NASDAQ: GOOGL) for $1,250 per share.
If you set a 10% stop loss, your position will automatically sell at $1,125 (10% lower than your entry price).
But let's suppose that GOOGL stock jumps from $1,250 to $1,500, and then - due to COVID-19 - retraces back to the $1,100 level.
If you only used a stop-loss of $1,150, you would have lost $350 from shares hitting $1,500.
Trailing stops would have automatically increased your stop loss to $1,350 (or 10% below your highest gain). This would allow you to sell at $1,350 and lock in a $100 gain from your original purchase price. Rather than facing a 10% total loss, you could have secured an 8% gain.
Trailing stops are a remarkable form of investor discipline, they and immediately remove the emotion of the selling process. Check your brokerage, as they are easy to set and monitor.
Which brings us to our "must have" risk management strategy...[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
Risk Management Strategy No. 1: Use Covered Calls
Now, this strategy is a bit more advanced, but it allows investors to generate revenue for almost any stock position that they own.
When you sell a covered call, you are "writing" a call option on every 100 shares of stock that you own. Covered calls enable four things that reduce risk and provide upside.
- They can generate income from your existing portfolio on stocks that already pay dividends or ones that offer no dividend.
- They reduce the cost basis of your original position by generating a premium from the sale.
- They offer a hedge that can reduce the amount of losses if your position goes in the opposite direction.
- Finally, they give you an effective exit target that can allow you to liquidate a position at your preferred price target.
So, let's return to our original hypothetical company ABC.
Let's say that you purchased 100 shares of the stock at $25 per share. Let's imagine that it's a growth stock that pays no dividend, but it has shown quite a bit of volatility in the past.
How can you generate extra income and protect yourself against any downside risk?
The answer is to write a covered call.
You could look out to the July options chain and find that the $28 call has a bid level of $2.
If you own the stock and it rises above $28, a buyer could call your position and take the 100 shares from you - for a premium of $2.
If you sell this contract, that $2 premium means that your exit position is worth $30 ($28 + $2). That would mean if the price rises above $28 and shares are called, you will generate $5 on your original $25 investment (or a 20% return.)
That said, let's imagine that shares rise to $27.50 but never cross the target level.
In this situation, you would keep the premium while your shares jumped 10%. Not bad. And best of all, you can go a few months out and again sell additional calls.
Now, here's the other benefit. Imagine that your shares fall from $25 to $24 over the next few months. Your basis would have declined by 4%.
However, because you sold that contract, you generated an 8% return from the premium.
Even though the stock has declined, you've successfully protected your downside using a covered call.
Why Startups Can Have an Edge During a Recession
Uber, Airbnb, Slack, Pinterest, and Venmo have something big in common - something other than their big names.
These startups were founded during the last recession.
And now, some of the most iconic companies of our time could launch into Fortune 500s during days like today.
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About the Author
Garrett Baldwin is a globally recognized research economist, financial writer, consultant, and political risk analyst with decades of trading experience and degrees in economics, cybersecurity, and business from Johns Hopkins, Purdue, Indiana University, and Northwestern.