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By Peter Temple

Friday, January 08, 2010.

Editor’s note: This article is targeted at UK-based readers. Please seek expert opinions before making financial commitments.

One of the neglected aspects of the investment scene has always been the application of systematic money management techniques. Those who do not practice these techniques suffer the consequences when market movements are extreme.

Money management in this context does not refer to making sure that surplus cash in a broking account gets the best rate of interest possible. It is rather the process of applying techniques that mean that no undue risks are run.

Probably the first rule, which sounds obvious, is to remember that losing money is painful and the more you lose, the harder it is to make back. Say you have £1000 to invest, if you lose 10% in an investment, this takes your balance down to £900. But in a subsequent investment you would need to make 11% to recoup the loss.

Lose 20% and you need gain 25% to get back to your original amount. Lose 50% and you need to double your money in a subsequent investment to recover your loss.

This argues strongly, not only for spreading risk, which I will come to later, but also for having the discipline to cut losses according to a systematic formula. This might be to sell automatically if an investment loses more than, say, 12% of its value, or to sell a profitable investment if it drops more than 15% from a recent all-time high. It depends on the type of investment and the circumstances.

But having a 'decision rule' like this helps take the emotion out of the action of selling a loss maker. Emotion is present because by implication selling a loss-maker means admitting to yourself that you made a mistake. For longer term investors, simply having the mental discipline to apply a rule this should be enough. For short term traders, using stop-losses should be an essential part of trading.

One other discipline is to know how much you can comfortably afford to lose on a single transaction and not to put more than that at risk. How you apply this depends on the type of investor you are.

A short-term trader, buying and selling volatile types of investments, like currencies or commodities, for example, might suggest not risking more than 1-2% of capital on a single trade.

For longer term investors, it comes down to knowing what your 'pain barrier' is, and sticking to it - bearing in mind that a profit warning or sudden announcement of financial difficulty can produce an instant sharp drop in price.

Taking losses without emotion is easier if you have adequate capital to begin with. This sounds trite, but it is a fact. If you are concerned about what might happen to your broader finances if an investment goes bad, then your money probably shouldn't be invested in anything that might prove unduly volatile.

Averaging down, adding to a holding in an individual share that has fallen in price, is a common error. Investors reason that if the shares they originally bought has gone down significantly, then it must be even cheaper than they thought.

The correct reason is that to buy more under these circumstances is to compound a mistake, and to put more money into a share that has already not acted in the way you expected.

Though it is counter-intuitive, the better strategy is to add to a share that has risen in price, not the other way around.
The danger with this, however, is that the share in question may have reached its correct value, and that to buy more is simply increasing your exposure to it, and therefore increasing your risk for a lower potential return.

Most investors feel intuitively more comfortable with a technique know as 'scaling out', which is selling part of a holding that has appreciated substantially in order to recoup a large part of the original book cost and leave the investment, as the phrase goes, 'in for nothing'.

Clearly this can only be done with a share that has risen very sharply and is usually only appropriate in smaller companies that have shot up for no apparent reason.

Peter says

Techniques like this have helped me make investment decisions over a period of more than nearly three decades as an active investor on my own account. Any scary moments or significant losses I have incurred have generally been when I have chosen to ignore them.

It is also important to adapt the techniques you use to the underlying market environment. One advantage private investors have over most so-called 'long-only' institutional fund managers is that they do not need to stick to being fully invested most of the time, nor do they have to stick to prescribed investment formula or type of investment.

Private investors can draw their investments from the whole gamut of the stockmarket, bonds, tangible assets and cash - remembering only that the same trading rules apply, and that those investing in tangible assets need to make allowance for the reduced trading liquidity that such investments have.

Equally it is worth bearing in mind that stock specific risk can be eliminated by using index funds or exchange traded funds (ETFs) instead (although not exchange traded commodities, which are more like single stocks in terms of the risk they pose).

With thanks to Interactive Investors.

Peter Temple was born in Yorkshire, UK. He has a degree in economics and worked in the City as an analyst for 18 years. Since 1988 he has pursued a career as a freelance financial analyst, financial journalist and author, contributing regularly to Interactive Investor, the FT and Investors Chronicle. 




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