So the question
stands - what do I do now?
The old adage is, don't try to catch a falling knife. But at
this point I am sitting on the sidelines and my entire target portfolio is a
falling knife. Have we hit bottom? Is the market going to recover? Or is the
European debt crisis and a slow down in China going to cause a double dip
and bring the S&P back to 900? Nobody knows. But based on fundamental analysis and market
research, we can identify equities that we believe will be good long term
investments and that appear to be undervalued today. The question remains, will they
be more undervalued tomorrow? To help limit my risk when entering volatile down markets like the one we have been experiencing, I like to use SmartStops exits and risk alerts.
I consider myself a value investor and get excited when I
see equities go on sale. However, my Archilles' heel is that I often get too excited and
enter early only to ride the investment down further before it recovers and
moves up. While long term I may end up
having made a good investment, I lament the opportunity cost of not having the
cash to buy when the stock fell lower. The following process helps me maintain
discipline, mange risk and capitalize on opportunities.
First, I identify my shopping list of 5 or so stocks that I
believe are great long term investments and undervalued today based on their
fundamentals and future business opportunities.
Second, if I feel the market may be turning and I am anxious
about missing a possible move up, I step in without fear. I can do this because I
am going to use stops to manage my downside risk. For this initial purchase, I like to use 50%
of my total target investment amount.
Third, I enter the position into my SmartStops portfolio and
use the SmartStops daily published short term exits and risk alerts to set my
stops and alert me to signs of increased risk.
If the market remains stable and I do not receive any SmartStop risk
alerts on my positions, I let this initial investment ride for a week or two
before revisiting my buying decision and committing
the remaining 50% of my capital.
If on the other hand an equity falls and triggers its SmartStop, I liquidate 50% of my initial
investment in that position leaving only 25% of my investing capital at risk. I then watch the stock or ETF, hoping it indeed does
go lower giving me a better entry point. If it does, I buy in at a lower price
and repeat the process. If I get
whipsawed and the stock immediately bounces up, I still benefit by having 25%
of my funds invested and can now begin to invest my remaining capital for the
long term. In this manner I step my way in and out if the equity continues to fall, limiting my losses and preserving my capital for use at a lower price.
The following Google example demonstrates the power of using stops to manage your risk as you enter into a down market searching for the bottom.
An investor may like Google as a long term investment believing there is real value anywhere below $550 and they may want to allocate $10,000 to this position. Using the process above, they may have experienced the following sequence of events these past few weeks.
We don't know what tomorrow brings, but we can take action as events unfold to manage our risk and capitalize on opportunities.
Have a great Memorial Day weekend.
Sincerely,
Chris
Christopher J. Conway
SmartStops.net
