The tricky part about volatility isn’t its wild swings… It’s that we want to believe these wild swings are meaningful, and they’re not.
When we see lots of green in the markets, our brains tell us more good times are ahead.
When we see lots of red in the markets, our brains tell us more pain is coming.
But we know only one will prove to be true.
Our brains want to fit the price action into a rational model… a sensible big-picture view of what’s going on.
But volatility is uncertainty. It doesn’t allow us the luxury of following a rational, knowable script.
Fortunately, we don’t need to know the script in order to make good trading decisions. We simply need to stick to the basics.
Today, we’ll review three of these investment basics. Even more important, we’ll look at how you can use them to survive and thrive in a volatile market environment…
1. Asset allocation
This is the piece of your wealth plan that deals with the amount of money you have in various assets. How much of your wealth is in cash? Stocks? Precious metals? Real estate? This all goes under the umbrella of asset allocation.
The No. 1 goal with asset allocation is to avoid taking too much risk in just one asset class… because when one asset class “zigs,” others will “zag.”
In this way, effective asset allocation allows you to sidestep financial disaster.
So when it comes to volatility, don’t let the swing du jour convince you that you shouldn’t hold stocks. Instead, beef up your allocation to “disaster insurance”…
Recently, in my DailyWealth Trader (DWT) newsletter, I recommended holding at least 5%-10% of your wealth in precious metals, at least 10%-20% in cash, and whatever you’re comfortable with in real estate and other commodities.
You’ll know you have the right asset allocation when big drops in stocks don’t scare you. Your gains in other assets will partially offset your losses in stocks… So you’ll be a lot less likely to make bad, emotional trading decisions.
2. Position sizing
Your position size is simply the percentage of your portfolio (or the dollar amount) that you allocate to a single position. A stock could make up 1% of your portfolio, for example… or 10%.
Obviously, you stand to make a lot more money if a 10% position makes a big move in your favor… And you stand to lose a lot more if it goes against you.
Pullbacks are often fantastic opportunities to open new positions. But if you start with a big position, volatility is more likely to get inside your head and cause you to sell at the wrong moment.
Instead, start with a small- to medium-sized position. Then add to that position as it moves in your favor.
3. Stop losses
A stop loss is a predetermined point at which you’ll sell a trading position… no questions asked. Stop losses are designed to limit risk and to remove emotions from your trading decisions.
When you use a “tight” stop loss (close to the current share price), you risk losing less… But you increase your odds of stopping out and taking that loss. When you use a “wide” stop (further away from the current price), you risk losing more… But you decrease your odds of stopping out, because the position has more “wiggle room.”
The type of stop loss you use should correspond to your confidence in the timing…
If you think you’re buying at the perfect time, you don’t need to risk 20% on the downside. A 5%-8% stop loss may be enough.
If you’re less sure of the timing, but you know you want to hold the position for a long time, it makes sense to use a wider stop loss. Maybe 15%-25% is appropriate.
In an uncertain market, volatility will likely knock you out of positions you open with tight stop losses. So lean toward using wider stops and smaller position sizes.
In short, these are the three keys to surviving and thriving in a volatile market. We’ve seen higher volatility this year… So now is the perfect time to put them to use. Follow this advice, and you’ll sail through market uncertainty with ease.
And here’s a bonus…
If you’re still uncomfortable with a new trade idea after you apply these three keys, pass on the trade altogether. Another trade will always come along.
Source: Daily Wealth