Refreshing Your Risk Management Approach

riskaheadDavid Fabian: Risk management has become a buzz word in the investment business with little real world application over the last several years. The need for stop losses, hedging, strategic asset allocation, and other counter measures to traditional market cycles has been overridden by a “buy the dip” mentality. Active investors have been conditioned to wait for a little speed bump and then race into the fray with extra cash to buy up stocks and ETFs.

It’s no wonder that this strategy has worked so well considering the big moves in volatility futures along with other greed/fear indexes. A 2-year look back at the CBOE VIX Volatility Index (VIX) versus the SPDR S&P 500 ETF (NYSEARCA:SPY) shows just how quickly investors go from bullish to bearish.


Every rally is met with skepticism, while every dip is quickly hedged with options, cash, or a flight to quality. This happens within a matter of days or weeks and the ship always seems to right itself in a very swift manner.

Risk managers have been punished under this regime as recency bias overrides the best intentions of those that remember how quickly things can change. 2008 seems like it was barely more than a dream as we plow to new all-time highs on a regular basis and celebrate the confidence that the Federal Reserve has bestowed upon us.

As a trend follower and sensible money manager, I have been participating in the strength of both stocks and bonds through a variety of low-cost ETFs. Nevertheless, I understand that one day the music is going to stop without notice and everyone will have to find a chair, less they risk falling solidly to the floor.

Trends can often last far beyond reasonable expectations, which is why I never take the tact of trying to call market tops and bottoms. I would much rather err on the side of caution (in both directions) by focusing on the price patterns relative to long-term moving averages. That way I am able to participate in the upside with the knowledge that I will have to one day step aside to avoid big losses.

During this period of relative stability and good will in the markets, I believe it’s prudent to refresh your risk management plan along with establishing sound trading principles in your portfolio. That way you aren’t caught off guard and making decisions under pressure when cycles change – and believe me, they will change one day.

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