Risk Management for Speculators & Trend Investors

Risk management is the absolute key to success for speculators and trend investors. If you can limit your losses and downsides, the upside will take care of itself.

Here are a number of rules to help you reduce risk in your trend investing portfolio.

1. Divide your total portfolio equity into equal sized portions.

Ten portions is good to begin with and you can expand to twenty equal portions as your portfolio equity grows and you gain access to more markets. Unless you are managing millions, there is no point into dividing your portfolio further. Keeping your portfolio equity portioned will help with setting risk levels and stop losses for each position later. It is also a good way to help you determine the number of markets you should monitor and trade.


2. Only put up to one portion of your portfolio to work in any one asset.

By limiting your bet size on any one asset, you are ensuring your portfolio stays manageable from a risk perspective and properly diversified for broad return potential. You never know which markets are going to make you your profits, so don't bet the ranch on just one or two assets. Cash, or short-term bonds, are a default holding so nearly your entire portfolio may be in cash if markets are not trending.


Example Assets Only

3. Trade diverse markets that provide returns which are independent of each other.

Trading only stocks and bonds will not provide you with a broad range of returns. Instead, monitor a range of uncorrelated and liquid assets: stock indices, currencies, precious metals, real estate, and bonds. If your account is larger and you have access to futures markets, include energy, grains, and industrial metals.

A lot of these assets can be traded with ETFs, but be careful to pick the right ones. You want liquidity and reasonable costs.


4. Determine the size of each position, including leverage, based on volatility.

Leveraging up your position can help increase returns on each position, but it also increases your chances of hitting a stop loss quicker than you need to. This can increase your whipsaw costs. Use Average True Range or Standard Deviation to measure the volatility of an asset. The asset's stop loss price should be a low multiple of ATR or SD.

Your stop loss price will help you determine an appropriate size for each position once leverage is factored in. Based on this formula, a highly volatile asset might be purchased with no leverage, or maybe less than a full position. Many assets can be leveraged up 2x to 5x or maybe more.


5. Never risk more than 2% of your current portfolio equity on any one asset.

Regardless of the size of the position and the amount of leverage used, the maximum loss of any trade should never be more than 2% of your portfolio equity. Newer and more cautious investors should start with a 1% maximum risk per trade. In dollar terms, if your portfolio equity is worth $100,000, your maximum equity loss on any of your positions should not be greater than $2,000. Limiting losses is the key to long-term success.

Source: Flickr - DoD News

6. Enter a Stop Limit Order on every trade set at your maximum risk.

To ensure your emotions don't get in the way of your trading, always place a stop limit order on every position. The stop price should be set at or near your maximum risk. Assuming you are risking 2% equity per position on a $100,000 portfolio, your stop price will never allow your total equity loss on any position to exceed $2,000. Move your stop loss up as your position becomes profitable, but never move your stop loss down.

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Why Leveraged Barbell Portfolios Win

Here's a little secret that every Couch Potato or Canadian Boglehead investor should know.

You Can Win With Leveraged Portfolios

In a rising market, leveraged portfolios handsomely beat Couch Potato portfolios. That should be obvious and I think it's fair to say no reasonable investor disputes this.

However, in a falling market, a properly constructed leveraged portfolio will also win. This defies the prevailing logic. However, the proof is in the data. Drawdowns are significantly reduced in leveraged portfolios when compared to vanilla buy-and-hold indexing.

There is no logical reason to continue absurd charade that no one can beat a Bogle-inspired, Couch Potato portfolio. It can be done, quite easily.

The Power of Leverage

No investor should underestimate the power of leveraged ETFs. These ETFs, whether 2x leveraged or 3x leveraged, can provide amazing returns in bull markets.

UPRO, a very popular U.S.-listed ETF tracking 3x leveraged to the S&P 500 Index, has generated a 40.6% CAGR since inception in June 2009 (yes, almost perfectly timing the beginning of the current bull market). An initial investment of just $10,000 would have grown to more than $200,000 today!

The tech heavy TQQQ, providing 3x leverage of the NASDAQ 100 Index, has generated a 51.1% CAGR since inception in February 2010. An investment of $10,000 just eight years ago would have grown to more than $270,000 now.

However, the problem with these ETFs is easy to decipher. If you have a 3x leveraged ETF, it takes just a 33% decline in the underlying market to make the ETF essentially worthless. The concerns surrounding leveraged ETFs is very real. If $10,000 climbs to $270,000 in eight years, but the $270,000 can become nearly worthless in just a matter of months, then these leveraged ETFs are just "too risky" for the typical investor.

Here is where the pundits are wrong. This oversimplified risk example that gets cited over and over is to every investor's detriment.

Leveraged ETFs are a tool to get more exposure for less outlay. Oversimplified a bit, if you put $10,000 to work in a 3x leveraged ETF, it is similar to putting $30,000 to work in a standard ETF. However, that doesn't mean you should put $10,000 in a 3x leveraged ETF if that is all the money you have!

Focusing on Safety First With Barbelling

I stumbled across the idea of simplified leveraged portfolios primarily through my reading of The Black Swan by Nassim Taleb and Trend Following by Michael Covel. The message of these books is simple: first limit your downside risks then amplify your upside potential. Seems simple enough.

The Black Swan espouses an especially interesting idea: barbell portfolios. Have 90% or more of your portfolio in boring, low-risk government bonds, then invest the remaining amount in very high risk instruments.

Taleb typically bets on market crashes, profiting from the ensuing chaos. For example, Taleb reportedly made approximately $40 - $60 million in profits from a call option bet on Eurodollar contracts and the Japanese Yen during the 1987 market crash. Taleb profited enormously as scared investors around the world piled into safe savings accounts, suddenly driving down interest rates and increasing the value of the Eurodollar contract.

The downside to Talebs strategy is it tends to only make money (albeit a potentially enormous amount) during market disruptions. These only present themselves every few years and the portfolio loses a small amount of money in between these periods. The instruments are also more difficult to access and understand for a typical self-directed investor who might not have the time or desire to learn about the futures options markets and roll over positions on a monthly basis.

However, can the concepts of barbelling be replicated in an easier buy-and-hold fashion? Absolutely!

Leveraged Barbell Portfolio Design

The first step of a Leveraged Barbell Portfolio is to hold short-term or mixed government bonds as your primary allocation. This means the majority of your portfolio will be in boring bonds. You should think of bonds as the amount of money you always want in your portfolio. The money you don't want to lose.

Next, you must decide which instruments you will use to drive your investment returns. There are a myriad of options here, but I believe 3x leveraged ETFs are the best choice for simplicity in registered accounts (where most investors have their money). These 3x leveraged ETFs are traded on the U.S. stock markets. The biggest providers are ProShares and Direxion.

Finally you must decide the amount of exposure to loss that you can tolerate, keeping in mind this portion will become worthless about once per decade on average.

Most investors can adequately come through a 20-30% loss in their portfolio without getting too panicked. However, some investors who are younger and have high savings rates can afford more risk. Whatever number you believe you can lose without great concern, that number is your capped exposure to leveraged ETFs.

The amount of your money you invest in leveraged ETFs should be equal to or less than your loss tolerance.

Using standard ETFs, a 20-25% loss tolerance would imply a hyper-conservative portfolio. However, using leveraged ETFs, you can actually obtain a much higher stock exposure and still achieve great returns.

While your risk tolerance should drive your allocation to risk assets, it is also important to understand how much underlying exposure you are getting to stocks based on the equity you are allocating to these leveraged ETFs.

Source: TheRichMoose.com

Historical Performance

Leveraged ETFs are new. The first products, 2x leveraged ETFs, came to market in the mid-2000s. They were primarily promoted as short-term or even day trading products for experts. This led to a cult of avoidance among self-directed investors, amplified and reinforced by continuous fear mongering.

This makes direct backtesting more difficult. Leveraged ETFs don't always track their underlying index perfectly. During high volatility periods they underperform and during low volatility periods they outperform their target return.

However, by extrapolating data going back to 1970, I have been able to come up with a representative backtest on how Leveraged Barbell Portfolios would have performed over more than four decades.

A portfolio allocated 60% to short-term bonds and 40% to 3x leverage of the S&P 500 Index would have generated a 15.3% CAGR.

A portfolio allocated 70% to short-term bonds and 30% to 3x leverage of the S&P 500 Index would have generated a 13.2% CAGR.

A portfolio allocated 80% to short-term bonds and 20% to 3x leverage of the S&P 500 Index would have generated a 10.6% CAGR.

This compares to a historical compound annual growth rate of 10.4% for the S&P 500 during the same time period and a 9.3% CAGR for a traditional 60/40 portfolio.

While investing all of your money in the S&P 500 would have made you sit tight through three drawdowns exceeding 40% of your equity, the Leveraged Barbell Portfolios would have done much better. The maximum drawdown of the conservative 80% bond portfolio would have been about 25%, the roughly the same as a traditional 60/40 stock/bond portfolio.

Over long periods of time, an increase of return amounting to just 1% per year can have a huge impact on your ending portfolio balance and your quality of life. If you invest $700 per month for 40 years, you will end with a portfolio of nearly $1.4 million at a 6% CAGR. If your investment return increases to just 7%, that portfolio will be worth over $1.8 million.

Thinking outside of the box, limiting your downside, and carefully using leverage with a Leveraged Barbell Portfolio can make you hundreds of thousands of dollars wealthier over your lifetime!

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