Sunday, November 13, 2011

Risk Management

I have read writings of Gerald Loeb, Jesse Livermore, Max Gunther, Nassim Taleb, Peter Lynch, Warren Buffet etc. on position sizing, loss cutting and various other risk management strategies and found many of them contradictory and unclear.
 In this blog I point out what each one said and then give my take on this-

Cutting Your Loses Early and Don't Average Down-
 This is probably one of the most controversial rules out there.
  • Buffet and Lynch basically advocate averaging down because of their value bent. If you think a stock is valuable $10 per share and when at $5 it should be of greater value all else remaining equal. If you don't average down then you need to sell the stock ASAP. Buffet says that you should have the stomach to take a 50% loss on your investment and not throw in the towel.
  • Loeb\Livermore\Taleb advocate using stop losses and getting out of bad situations early. 
  • Taleb makes an interesting point which contradicts his stop loss rule  which is - "The markets will follow the path to hurt the highest number of hedgers. The best hedges are those you alone put on". What this means is that if most people use stop loses to hedge their positions then most of the time stop loses will be triggered irrespective of the direction of the stock.Now you could argue that stop loses are not hedging but my take is any loss minimization program is a hedge. 
  • My take: Automatic stop loses means that market maker will constantly trigger  your stop loses because of the hedging rule by Taleb. My take is Lynch\Buffet have the best rule for success with some caveats. You need to understand the business thoroughly before you average down. Companies with debt coming due or companies needing more cash means that you are at the mercy of others.

Invest Only In Things You Understand-
  • Taleb,  Buffet and  Peter Lynch argue for that but for different reasons. Buffet\Lynch think that you invest in businesses not stocks and more you understand what you buy better you are. Taleb argues that price action on instruments you trade need to be understood.
  • Livermore\Loeb are a pure macrotrader where he says that in a bull market all things on up and in a bear market all things go down. You need to worry about the larger trend\general conditions and  not about individual fluctuations.

Position sizing-
Buffet\Lynch\Gunther all advise on holding max 5 holdings. Any thing more you are diversifying for the sake of diversifying anything less you are increasing your risk. Market risk cannot be eliminated but firm risk can be reduced by diversification.

Buy and Hold-
  • Lynch\Buffet all want you to hold for the long run disregarding the recession.
  • Livermore wants you to hold until bull market ends.
  • Gunther wants you to take profits quickly.

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