Risk and reward are inseparable aspects of trading stocks, but that doesn’t mean we throw risk management out the window. While many suggest that bigger rewards require bigger risks, don’t be fooled… they’re just setting up an excuse in advance for when they misapply the common risk management techniques they espouse. By the way, if you just skipped over those two highlighted articles, you may want to familiarize yourself with them before going on. They form the basis of our discussion today.

Risk Aversion to the Extreme

Stories of single stocks such as BP imploding due to a ecological disaster or Enron dissolving under corrupt executive or even Toyota halting production in several plants due to an earthquake leave some to wonder just how safe it is to invest in individual stocks. Due in part to this risk aversion, the Exchange Traded Fund has emerged in recent days with increasing vigour among average investors who want a little bit of a sector or commodity, without the risk of one individual stock.

Understandable! But, really, why stop there? Why not simply buy the index? In fact, many investors have decided to do just that… and they refer to it as “passive” investing. Using index tied instruments, they “buy-and-hold” often relying on the dividends to increase their net worth. The simple belief is risk over time is reduced. When you look at Gold over the past 10 years, you might find some reasonable evidence there for such a strategy. Yet, if you apply it to a blue chip like GE, you’ll find a different tale.

So, all investors (active or passive) are faced with the same challenge of choosing investments that will produce profits without maximizing their risk.


Principles of Risk and Reward

Invest in the Markets is about preserving capital, minimizing risk, and maximizing returns… a clear objective that emphasizes protection. But there’s no need to take risk aversion to the extreme. Instead, we simply need to follow some rather simple principles to help us remain disciplined and less emotionally driven. Here’s a few for your consideration:

Use Position Sizing – In the article “Applying Risk Management to Investing in the Stock Market” we addressed position size as it compares to overall portfolio size. What I didn’t share was the following two principles: First, I never invest more than 10% of my overall capital into any one position. Some would suggest this is way too high… and I won’t argue the point. After all, I think it is more of a personal preference than golden rule. The point is, you want to have some diversification in your portfolio, so limiting any one position to 10% of your portfolio forces the issue. Second, when the markets are in a downtrend, I cut my typical position in half for all new investments. In other words, if you normally in $10000 into a stock, reduce it to $5000. The only exception is inverse positions (ones that rise while the markets fall). This would be a great time to remain in a full position. Conversely, when the markets are in an uptrend, I place only full orders (except for the inverses, which would be half positions). A lot of attention is given to what to buy, and when to buy… now apply one more step, namely, how much to buy.
Never Chase – There are dozens of ways to say this… but let me show you a few. Buying on the dip when the stock is dropping (often under the guise of dollar-cost averaging) increases risk without reward. Also, chasing a stock (either up or down) once you’ve missed your entry point increases risk… especially if it’s a losing stock. If you find you’re missing stock opportunities, then reconsider the number of stocks you’re watching… it’s likely your watch list is too large for the time you can commit. Finally, buy the rise… it is one of the leading principles of Invest in the Markets.
Three Strikes, Opt Out – When you have three losing trades, step away and reevaluate. One of the most crippling things you can do to your investment portfolio is allow multiple trades to lose. Remember, it is far more difficult to recover lost money than make money from an even balance line. That’s why the first part of the motto is: “Protect capital.” If you don’t have a trading journal, this is a great time to start one. It’s time you record what you’re doing so you can have greater success with future trades.

Risk Management Free Webinar

I know it’s not just me… writing and reading about risk management is a challenge. So, I’ve decided to launch into the world of Webinars by hosting my first one on Risk Management on January 22nd, 6pm EST. I’ll be explaining a few ideas that can save you thousands of dollars as you learn to manage risk so we can maximize returns. Here’s a few ways to stay in touch with the sign-up details:

Follow me on Twitter (@DoctorStock).
Send me an email – I’ll notify you how you can sign up.
Subscribe to the Weekend Newsletter – You can try it completely risk free for 15 days.
Keep reading – I’ll be updating you in future articles.

Successful traders know how to manage risk… in fact, it is the most common theme among those who have “learned the hard way.” We all want the reward of profitable investing. The great news is you don’t have to take unnecessary risks to accomplish this objective. Risk and reward are inseparable aspects of trading stocks, so we simply need to learn how to manage risk to ensure our success as investors.