Time to Reevaluate Your Risk Management

This article originally appeared at InvestmentU.com. Reprinted with permission.

The current dip in stocks is dangerous. Not because it’s a long-term sign of things to come but because investors have forgotten all about downside risk. Considering we haven’t had a 10%-plus correction in more than 2 years, that’s understandable.

But when the Fed stopped its bond-buying program in October, we did see a strong stock market sell-off. The question is: Was it enough of a sell-off, or is there still more to come?

In either case, now is the perfect time to reevaluate your risk management plan. Especially considering the Fed just ended its third round of quantitative easing (QE).

To get an idea of how this will affect stocks, let's look at what happened at the ends of QE1 and QE2.

End of QE1

The first quantitative easing program ended in March 2010. Notice a quick sell-off in the months leading up to the end of QE1. After this, there was a 16.02% peak-to-trough decline in the S&P 500.

Of course, the European sovereign debt crisis, the Deepwater Horizon oil spill, and the “flash crash” also contributed. But most investors agree that the Fed has been the main driver of market action since 2009.

End of QE2

QE2 ended in June 2011. Notice the quick sell-off that began in May. As soon as QE2 was over, the S&P 500 saw a peak-to-trough decline of 18.28%.

It’s worth noting that at that time, we were simultaneously dealing with a deadlocked Congress, which ultimately caused the first U.S. credit rating downgrade in history.

End of QE3

October saw only a 6.3% decline in the S&P 500. And instead of a dip before the end there was a dip leading right into the end.

This brings us back to our original question: “Was it enough of a sell-off, or is there still more to come?” We don’t know if there will be a harsher wave of selling like we saw the last 2 times around. And it can be difficult to predict if major geopolitical events like the ones we saw near the ends of QE1 and QE2 will occur.

In addition to the end of QE3, investors are also turning their attention to whether the Fed will raise rates this year. Some thoughts on that:

• International markets are in turmoil, which is one reason why Janet Yellen may have kept the words “considerable time” in her statement. This argues for lower rates for the time being.
• The Fed thinks it’s going to finally hit its employment goal within the next year. This argues for rate hikes in the near future.
• The sharp decline in oil prices altered the Fed’s outlook. Its inflation forecasts of 1.6% to 1.9% were lowered to 1.0% to 1.6% for 2015. This is well short of the 2.0% goal, which argues in favor of keeping rates low until further notice.
• Core inflation (prices excluding food and energy) hasn’t really changed. The Fed forecasts core inflation will rise 1.5% to 1.8%, which is slightly down from its September forecast of 1.6% to 1.9%.

Rather than try to figure out when the Fed will raise rates or what language it will use next or even what the stock market is going to do, it pays to simply ride the uptrend. Just do so with solid risk management strategies.

For long-term positions, The Oxford Club recommends using a trailing stop loss order, “good-till-cancelled,” of 25%. For short-term positions, your stop loss order may be much tighter or you might consider using option contracts to hedge against possible volatility.

The smartest way to stay safe is to diversify and use responsible position sizing. In times like these, when you have record-breaking uninterrupted uptrends, investors become overcomplacent. They also become very gutsy, which is usually a mistake.

So make sure you’re not part of the herd and instead play it safe. Remember: It’s not what you make, it’s what you keep.

Christopher Rowe is a technical strategist at InvestmentU.com. The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician's Money Digest should be considered personalized investment advice. Physician's Money Digest, its writers and editors, and Intellisphere LLC and its employees are not reponsible for errors and/or omissions.