Portfolio And Risk Management Part 1 – Learning To Minimize Losses And Maximize Profits

Over the coming months I will write a series of articles for our subscribers that relate to how to manage your capital for out sized annual returns. It is my hope that collectively this set of articles will memorialize a host of subjects that you will not only incorporate into your written investment and trading plan, but will provide some backbone to how one best utilizes our form of analysis into realizing consistently high annual returns.

While previous articles don’t share the title “Portfolio and Risk Management”, the principals expressed in those articles are no less imperative to understand, and in truth should be part of this series. As such, please refer to Achieving your Financial Goals and How To Size Exposure under the Getting Started tab.

What is causing me to begin with a discussion relating to how to minimize losses and maximize profits relates to a very constructive email I received from one of our subscribers, Edwin Deitch. A special thanks to Edwin for his comments. Along these lines, if anyone of you has thoughts or questions on how we can better help you and other subscribers to better utilize our analysis, please don’t hesitate to send me a private message. Both Mike and I are keenly interested in helping our subscribers make real profits.

To begin with, it is imperative to understand what we are doing here on The Active Investor site. We are using a combination of modalities to determine low risk relative to high reward short, intermediate, and long term investment opportunities, or what we will commonly refer to as trade setups. By low risk relative to reward, we are simply referring to the opportunity skew. The modalities we primarily use is Elliott Wave chart analysis combined with Fibonnaci math that provide us with opportunities to enter positions whereby the amount we are risking, or in other words the level that a particular trade would invalidate our primary thesis, is considerably less than our expectation of price movement. The typical risk to reward profile may vary from a very high reward relative to risk, to a more normal reward relative to risk. A typical reward relative to risk opportunity might be 4:1, where we are risking $1.00 to make $4.00. A high reward to risk opportunity might be 10:1, where we are risking $1.00 with the potential to make $10.

As an “Active Investor” you are chartered with always understanding the relationship between the amounts of risk you are taking versus the reward, and then managing your exposure size accordingly. When the trade setup is clean and clear, and the reward relative to risk is extremely high, and provided one considers things like gap risk into the equation, then increasing exposure size makes sense. Alternatively, if the scenario provides less reward relative to the risk being taken, then exposure size should be reduced.

Using Elliott Wave and Fib levels is not perfect, in the sense that it’s not always going to provide an outcome consistent with our primary thesis – primary count. The result in being wrong is that those who take positions will simply exit, or stop out with a relatively small loss on their position. It maybe intuitive, but warrants saying that taking losses is as much of part of investing using this investment approach as realizing or taking profits. Over time, when one is diligent in their approach to risk management, the result will always be significantly higher returns versus losses. As Paul Tudor Jones so eloquently states – “Where you want to be is always in control, never wishing, always trading, and always, first and foremost protecting your butt”.

If you are managing your positions appropriately, then you should always know precisely where you will exit at all times to protect both your hard earned capital, and certain accumulated profits. If you do not know these things at all times, you have effectively toggled over to a form of risk management that is driven by words like “hope” or “wish”. This posture adds an element of emotion to your decision process that is not only toxic to your life in general, but forces you to make decisions that are quite often not in the best interest of the net liquidation value of your account.

Never count your eggs before they hatch

If there is one thing that long experience has taught both Mike Richards and me, it is that Elliott Wave is an excellent tool to identify high reward to risk opportunities, but that price always rules. In other words, regardless of the outcome of the most skillful Elliotticians primary thesis, when price chooses a different path than what was expected as one’s primary thesis (primary count), then it’s not the Elliott Wave count that is wrong, it’s the analysts interpretation of the count that’s wrong. To suggest that one is always going to be right rejects a few basic truths – 1. We are only human; and 2. We are not clairvoyant. I am completely amused by certain Elliott Wave analysts who post a multitude of potential Elliott Wave counts, most times in completely opposing directions to each other, and then later refer to the one that came to fruition to claim their accuracy. The reality, as we all know full well, is that as investors are simply unable to trade both directions at the same time, as this results in a wash and is akin to having stayed in a cash position to begin with.

Many times there are several potential Elliott Wave patterns that are diametrically opposed to each other, but where we are able to use a host of other tools to accompany the Elliott Wave alternatives in order to establish which is most likely. It may also be that one offers an enhanced risk relative to reward scenario, and when including these criteria into the equation it makes more sense to favor one directional move versus the other. However, the simple truth is that often times what appears to be the start of a particular directional move in our favor results in a pattern that morphs into something different than was originally expected. It is for this reason that one must always be diligent about managing risk. Once you are in a trade that is going in your favor, there are a number of ways to manage the variable degree of risk associated with an ongoing position, as follows:

1. Once a trade that is reasonably in your favor, always exit a portion of that position by taking a profit. This way, if the pattern morphs into something unforeseen, you can exit the other half at a small loss or break even, and still end up with a nice overall profit.
2. In the case of tracking an overall impulsive wave structure, always exit the entire position at the wave iii level. Many times an ABC structure is identical to a 1 2 3 structure. The only real difference between an impulsive versus a corrective move is that an impulse includes a wave 4 and 5. It is for this reason; therefore, that exiting a position on the completion of a 3^rd wave is always advisable. If a wave structure is going to morph into something different, this is the place it will most likely morph, and by the time the 3^rd wave has completed, most of the profits have been realized. In addition, the risk to reward skew has now completely changed and no longer possesses the same skew characteristics that pulled you into the position to begin with.
3. Once an investment position has gone in your favor, raise your stop out level to minimize all or the remaining portion of your trade position.
4. Go into a trade position with the full knowledge that the Elliott Wave count may morph into something different than was originally anticipated. In other words, never expect an Elliott Wave count to follow through unless it does so. Always expect the unexpected. These are markets driven by sentiment, and while a particular Elliott Wave count may be following through as expected, it is imperative for it to adhere structurally to the pattern, and at the first sign it is not, then either exit, or make sure to raise your stop out levels such that you protect profits while at the same time allow your thesis to follow through.

Collectively, among other things, these areas of discussion fall into the category of good risk management. Over time, as you manage yourself into positions, then effectively manage those positions until you have exited them where you are functionally able to minimize losses, you will find that the collective returns in your account will astound you.

We are all seeking to be Active Investors, because as an active investor we are able to achieve super performance that is both consistent and at elevated levels to those of a passive investor. However, it’s important to keep it real.

The only other remark I’d like to make relates to expectations for returns. Is it possible to achieve enormously high annual returns? Yes, of course it’s possible. However, in order to achieve super performance that is well in excess of 25% per year, it will require two things – 1. Work and effort to allocate to the right setups; and 2. Rigid risk management. We will go periods of time where the right setups are not so plentiful, and then we will see other periods of time where the right setups are in abundance. Being diligent, and if you are diligent in your efforts to expose capital to a number of high reward relative to risk scenarios, there will be a portion of each year where you simply “mop up” on your overall performance. However, is you fail to exit positions with small losses during the balance of the year, you may find yourself simply making back what you previously lost, and this is not an acceptable approach to managing risk.

In conclusion, Elliott Wave is not perfect. You cannot trade markets in both directions at the same time. You must therefore work to identify those scenarios that offer high rewards relative to the risks being taken, and then expose capital to these scenarios as often as you and the markets will allow. Once you’re in a position, risk management is ongoing. Never trust that the outcome of an intermediate Elliott Wave count is a given, and always assume until it provides price level confirmations that it can morph into something different than original expected.

We have incorporated a number of technical tools together that when combined with our Elliott Wave analysis provides for an elevated level of confidence. However, this does not mean one should not rigidly manage risk at all times.