If you have found this article you most likely already know that the Magic Formula is a well-known investment strategy from Joel Greenblatt’s book, "The Little Book That Still Beats the Market." It looks for companies with high earnings yield and high return on invested capital.
Even though the strategy is very effective, adding risk management can make it even better. This article will show you advanced risk management techniques, like portfolio rebalancing and stop-loss orders, to protect your capital while still getting the excellent returns the strategy is known for.
Risk management is crucial because it helps you handle the ups and downs of the stock market, not just by lowering your losses but emotionally. This helps you stick with the strategy over the long term. Also, by using risk management strategies, you can keep your portfolio stable and growing, even when the market falls.
Key Points: Magic Formula focuses on high earnings yield and return on invested capital. Risk management techniques enhance portfolio stability and performance.
Understanding the Magic Formula
Before we get to risk management first a bit of background information.
The Magic Formula helps you find good, cheap companies. It ranks companies based on earnings yield and return on invested capital (ROIC).
Earnings yield helps you find cheap companies, while ROIC lets you find quality companies that best use their money to make profits.
Combining these two, the Magic Formula ranks companies to find the best ones.
The strategy really does work!
Greenblatt’s Magic Formula has been tested and proven in many markets. Studies show it works well in both the U.S. and Europe. This consistent performance makes it a great investment strategy, but adding risk management can make it even better and safer for your investments.
Key Points: Magic Formula uses earnings yield and ROIC to rank companies. Proven effective in different markets, enhancing portfolio returns.
Why Risk Management is Crucial
The Magic Formula has shown great returns over time, but it is still affected by market swings. Using advanced risk management techniques can help you reduce these risks and keep your portfolio losses low. This helps you stay disciplined so that you can stick with the strategy.
Also, by having a clear risk management plan, you can avoid making irrational decisions during market drops, like selling out completely at the market low. This discipline is the key to keep you sticking to your strategy when times are tough.
Key Points: Market volatility affects all investment strategies. Risk management reduces its impact and maintains your portfolio’s stability.
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Advanced Risk Management Techniques
1. Portfolio Rebalancing
Rebalancing your portfolio means adjusting your investments to keep your planned investment in each idea. For a Magic Formula portfolio, this means regularly checking and adjusting your stock allocations based on their performance.
Rebalancing helps you make sure no single stock or sector becomes too large in your portfolio. This reduces the risk of any one stock or industry sector causing a big loss.
You can rebalance your portfolio on a set schedule, like every quarter or year, or when a stock’s weight goes beyond a certain limit. This helps you keep a balanced portfolio that fits your goals and risk level.
It can also boost returns by selling high-performing stocks and reinvesting in new Magic Formula ideas.
Key Points: Rebalancing maintains a balanced portfolio and reduces risk. It can enhance returns by selling high performers and reinvesting in undervalued stocks.
2. Stop-Loss Orders
Stop-loss orders are great for managing risk in your portfolio. A stop-loss order automatically sells a stock when its price falls to a set level, for example, 15%.
There are two main types:
- Traditional stop-loss, where you set the stop loss level below the purchase price, and
- Trailing stop-loss, which adjusts as the stock price rises. This means you adjust the stop loss price up as the stock price increases. It is the type of stop loss we recommend you use.
For more information on exactly how and why trailing stop losses work best look at this article: Truths about stop-losses that nobody wants to believe
The above article shows you why stop-loss strategies can improve returns and reduce volatility. A trailing stop-loss, for example, helps you lock in gains as the stock price goes up while protecting against big losses. Setting a trailing stop-loss at 15% or 20% can help you avoid large losses and protect your portfolio.
It’s important to stick to your stop-loss strategy consistently, even when it’s hard to sell losing stocks. This is harder to do than it sounds.
Key Points: Stop-loss orders help manage downside risk. Trailing stop-loss can lock in gains and protect against large losses.
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Emotional Discipline in Risk Management
Using a stop-loss strategy requires sticking to your rules, which can be hard due to emotions.
For example, investors often hesitate to sell losing stocks, because it is emotionally painful and because they hope that they will bounce back.
It is thus very important that you stick to the stop loss rules you have set for your portfolio. For example, selling if a trailing stop loss of 15% or 20% is breached.
What you can also do to stop you from trading too much is to check stop loss levels monthly or weekly (that is what I do). This way, you can stay committed to your strategy and avoid making decisions based on short-term market changes.
Key Points: Emotional discipline is vital for following stop-loss rules. Regularly review your stop loss levels but avoid daily monitoring to keep trading costs low.
Timing the Market: Avoiding New Investments During Downturns
Market downturns can hurt your portfolio because new companies start falling as soon as you have bought them. Not only is this emotionally painful but if they keep on falling you will soon sell them because your stop loss level will be triggered.
To reduce this risk, avoid buying new stocks when the market is trending down.
A way to do this is to stop buying if the market index is below its 200-day simple moving average (SMA). Testing we have done found the 200-day SMA works well but if this is too slow acting for you 100 days is a good alternative.
This helps protect your capital during volatile times and ensures new investments have a better chance of success.
Key Points: Avoid new investments when markets are below their 200-day SMA. This helps protect capital and improves the chances of successful investments.
Conclusion
As you have realised investing can be emotionally hard. Thus, risk management is vital if you want to stick to your Magic Formula investment strategy over the long term.
By using techniques like portfolio rebalancing and stop-loss orders, and market timing you can protect your investments from big drops and boost long-term returns.
Will it always increase your returns? No, it will not but it will let you stick to the strategy over the long term and that is really the most important point.
By keeping your emotions in check and timing your market entries carefully, you can invest with more confidence. As you refine your strategy, these advanced risk management techniques will help you build a strong and successful Magic Formula portfolio.
Key Points: Risk management techniques protect investments and enhance returns. Discipline and sticking to your strategy are crucial for long-term success.
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Magic Formula Risk Management Frequently Asked Questions
1. What is the Magic Formula and how does it work?
The Magic Formula is an investment strategy introduced by Joel Greenblatt in his book, "The Little Book That Still Beats the Market." It focuses on finding companies with high earnings yield and high return on invested capital (ROIC). This method helps identify good, undervalued companies that are also efficiently using their capital to generate profits.
2. Why is risk management important in investing?
Risk management is crucial because it helps protect your investments from market volatility. By using techniques like stop-loss orders and portfolio rebalancing, you can minimize losses and maintain emotional discipline, which is essential for sticking to your investment strategy over the long term.
3. What is portfolio rebalancing and how do I do it?
Portfolio rebalancing involves adjusting your investment amounts to maintain your desired level of exposure to each stock. For example, if one stock grows significantly, it might take up too much of your portfolio. Rebalancing means selling some of that stock and reinvesting in other stocks to keep your portfolio balanced according to your goals.
4. How do stop-loss orders work?
A stop-loss order automatically sells a stock when its price falls to a predetermined level, such as 15% below its purchase price. This helps limit potential losses. A trailing stop-loss order adjusts the stop level as the stock price rises, allowing you to lock in gains while protecting against significant declines.
5. How can I avoid making emotional decisions during market downturns?
To avoid emotional decisions, establish a clear risk management plan and stick to it. Use stop-loss orders and regular portfolio reviews to maintain discipline. Avoid checking your investments too frequently, as this can lead to impulsive decisions based on short-term market movements.
6. What are the benefits of using a trailing stop-loss order over a traditional stop-loss order?
A trailing stop-loss order adjusts the stop price as the stock price increases, locking in gains while still protecting against large losses. This dynamic approach is more flexible than a traditional stop-loss order, which remains fixed at a set level below your purchase price.
7. How often should I rebalance my portfolio, and what factors should I consider?
Rebalancing frequency can vary, but many investors rebalance annually. Key factors to consider include changes in stock performance, sector weightings, and your investment goals. Regular rebalancing ensures that no single stock or sector becomes too dominant in your portfolio, reducing overall risk.
8. How does the 200-day simple moving average (SMA) help in timing market entries?
The 200-day SMA is a long-term trend indicator. If the market index is below this average, it suggests a downtrend, and it might be wise to avoid new investments during this period. Conversely, when the index is above the 200-day SMA, it indicates an uptrend, providing a more favourable environment for new investments.
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Please note: This website is not associated with Joel Greenblatt and MagicFormulaInvesting.com in any way. Neither Mr Greenblatt nor MagicFormulaInvesting.com has endorsed this website's investment advice, strategy, or products. Investments recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website.
