When an investor accepts that losses are inevitable, the next logical step is to manage the size of that loss. Any time you have a protective exit in place, like a sell stop, there is a chance that it will be triggered. This should lead to two questions:

• How much will I lose if this position immediately declines to my stop?
• How many of these losses can I sustain?

The point of position management is to design an approach that allows you to survive an extended streak of adverse outcomes (bad luck) or a broadly correlated selloff that sinks a large number of positions at the same time (bad market). Losing 5% of your account equity on a position that goes awry is survivable. However, if that were to happen eight times in a row, or to ten positions at the same time, the odds of recovery are dramatically reduced. What is tolerable in isolation can be a disaster in aggregate.

One way to influence the survivability of adverse events is in the constant measurement of the risk posed by the gap between the current price of a security and it’s protective exit price. By limiting that gap to, for example, an amount that equals 1% of account equity, we can suffer a prolonged series of setbacks while preserving our ability to recover and move forward during more favorable conditions.

While simple in concept, in practice it can be complex. The calculation of account equity constantly changes as security prices change, dividends and interest accumulate, money is withdrawn, etc. Most exit strategies incorporate some type of trailing stop, so exit prices are also changing on a regular basis. All of this needs to be reconciled in an effort to keep drawdowns within tolerable limits. At the same time, we need to assume enough risk to benefit when conditions are favorable.

It has been my experience that a drawdown – a decline from a recent high-water mark – is the condition most associated with risk for investors. People generally are unconcerned with volatility when it is to the upside, but drawdowns invite the specter of permanent loss. Large drawdowns can erode confidence and result in a dramatic change in investment approach, which in turn can expose the investor to a whole new set of unappreciated risk factors.

Maintaining strict limits on position exposure forces us to reduce the size of an investment that grows at a much faster pace than its protective exit price. When an exit strategy takes volatility into consideration, position limits become a self-correcting mechanism that constrain the size of a volatile holding to a higher degree than a more stable investment. Dynamic position management is, in my opinion, the most important component of portfolio management.

Having said that, it has to be noted that taking an active step to monitor and manage drawdown risk is not foolproof. If risk could be completely managed, it wouldn’t be risk.