AFP Defined Risk Strategy

Our risk management process is designed to help limit large losses that typically result from short term fear selling in the stock market. It is essentially a stop-loss process that is triggered when specific equity indices trade down below a particular moving day average threshold (we sell stock positions on this trigger.)


History shows us that most large stock market declines have occurred when the stock market drops below its 200 day moving average. By selling stocks at these transition points, we seek to sit out of the market until whatever is causing the market panic subsides.

How Does It Work?

In our managed accounts process, we apply this defined risk approach to a portion of the stock allocation of a diversified portfolio.  If the market trades down a certain percentage below its 200 day average, we sell these stock portions.  We separate into domestic and international and apply triggers to each, as different influences tend to impact these markets separately.


After we go "risk-off", we then track the same indicies and look for the market to recover back above these 200 day moving averages before we re-enter.  To reduce excessive trading, we also apply a % trading window above and below these targets so that we do not find ourselves buying in and out repeatedly in short periods of time.

"Risk-On" (we own stocks)

The shaded areas show the periods of time that the S&P 500 index traded above its 200-day moving average during the past 10 years (about 80% of the time.)

"Risk-Off" (we do not own stocks) 

The shaded areas show the periods of time that the S&P 500 index traded below its 200-day moving average during the past 10 years (about 20% of the time.)

Why not stay invested all the time?

One of the findings of behaviorial finance studies is that people have a larger emotional response to losing than they do winning.  A byproduct of this human instinct is that when our investments lose value, we are tempted to a much larger degree to take action, usually the action of selling.  The more people sell, the faster a selling frenzy can ensue.  What many people fail to realize is that it takes a positive return of a far greater magnitude to make up for a large loss.  


Consider this chart:

What this shows us is that we need to make far higher positive returns to get back to 0% if we experience large negative returns.  

Knowing that historically most large declines occur AFTER the markets fall below their 200 day moving averages, not being invested in stocks once these moving averages are reached on the downside can help us defend against the higher probability of large losses.

Should this strategy be used as a complete portfolio solution?

In our opinion, no.  This defined risk strategy should be used in conjunction with a diversified asset allocation strategy.  There are many ways to diversify an investment portfolio against market risks.  This paticular strategy is simply designed to create a short term "floor" on the portion of a portfolio that is invested in the broad stock market.  If one were to use this strategy exclusively, many of the long term benefits of diversification would be lost.  Additionally, this strategy does not work well in a very volatile, but fundamentally sideways market cycle because of trading costs and execution issues associated with the specific timing of the trades in and out of risk assets.

How much does it cost?

Running this strategy is surprisingly inexpensive compared to most actively managed investments.  Because we can combine the low cost of indexing with a low number of expected trades each year, we find that the total cost to run this strategy is between 0.09% and 0.35% depending on which ETF or fund we use for domestic and international stock exposure.  There are some labor costs for us to monitor various triggers, but we absorb that as part of our standard account service costs or advisory fees.

Can this strategy work over the long term too?

Interestingly the results of this approach over the long term are quite similar to what we have seen recently.  Typically this defined risk strategy would have triggered a "risk-on" status about 70% of the time and "risk-off" about 30% of the time during the past decade. 

Be sure to ask your advisor to provide you with more information on how you can take advantage of the AFP Defined Risk Strategy.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. 

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