| Free Article |
The Importance of Controlling Risk and Minimizing Losses in
Stock Investing
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS OF 2010:
How to Generate Wealth or Income from Dividend Stocks
October, 2006
Portfolio management is largely about managing risk. Warren Buffett said, “The
first rule is not to lose. The second rule is not to forget the first rule.”
“Managing risk” means doing things that safeguard your money from the
possibility that any investment decision may be wrong. Therefore, risk
management includes any practice that:
• Lowers the inherent risk in investing in stocks—recognizing that all stock
market transactions carry some risk;
• Increases the probability that your stock investments will profit (or, stated
another way, lowers the risk that you will miss out on making money from good
opportunities);
• Takes you out of harm’s way by exiting individual stocks or the entire
market when conditions warrant.
Risk management is not a prediction that things are going to go bad, but it is a
defense against the possibility that they might go bad. Contrary to popular
opinion, avoiding outsize losses—not hitting the occasional “home run”—is the
most important factor in beating the market.
Every risk management maneuver, itself being an investment decision, carries
its own risk. The risk in risk management is that it will make you so cautious
that you will not make as much money as you would if you accepted more risk.
For example:
• Easing into a stock position through multiple purchases—a common risk
management technique—will cost you money if the stock goes straight up after
your initial purchase. It is not money you lose, per se, but money you fail to
make by not buying the stock all at once in the first place.
• Selling a stock because of a short-term price drop will stop your losses in
the short term, but if the stock reverses itself and goes back up and beyond the
price at which you sold it, the decision to sell will cost you the profit you would
have made if you’d simply hung on to the stock.
• Diversifying will cost you money compared to what you would have
made if only you’d known which single stock in the universe was going to do
the best and just bought that.
So why practice risk management? To protect against devastating losses. In the
long run, your returns are most likely to beat the market if you avoid outsize
losses. The idea is to balance risk vs. reward opportunities in order to produce
the greatest return in the end.
Risk management techniques range from the extremely simple—like easing your
way slowly into the market—to highly complex activities utilizing sophisticated
investment products and strategies that are beyond the ken of the average
individual investor. In this regard, one often hears the term “hedging.” Hedging
is a subset of risk management. The term usually means buying (or selling)
something—like another security, an “option,” or your own stock short—which
theoretically offsets the risk of what you already own. The Sensible Stock
Investor manages risk using simpler techniques.
Why is controlling losses so important? Because it is so hard to make up for
them. Let’s look at a few examples. If you lose just 5% in a stock, it only takes
about a 5% gain to make up for it. But as the percentage of loss grows, the
percentage you must then gain—just to get back to even—grows geometrically.
A 25% loss takes a 33% gain to get back to even. A 50% loss takes a 100%
gain. Some of the dot-com high-flyers of the late 1990’s lost 90% of their
market value. What do you think it will take to get back to even? A 900% gain!
Realistically, that’s not going to happen.
So the Sensible Stock Investor avoids outsize losses in the first place. The new
book, Sensible Stock Investing, describes in detail the relatively simple
techniques that the individual investor can use to sidestep large losses—such as
not using margin, not selling short, and controlling losses with sensible sell-stops.
Remember Buffett’s Rule #2: Don’t forget Rule #1. And what was Rule #1?
Don’t lose.
Stock Investing
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS OF 2010:
How to Generate Wealth or Income from Dividend Stocks
October, 2006
Portfolio management is largely about managing risk. Warren Buffett said, “The
first rule is not to lose. The second rule is not to forget the first rule.”
“Managing risk” means doing things that safeguard your money from the
possibility that any investment decision may be wrong. Therefore, risk
management includes any practice that:
• Lowers the inherent risk in investing in stocks—recognizing that all stock
market transactions carry some risk;
• Increases the probability that your stock investments will profit (or, stated
another way, lowers the risk that you will miss out on making money from good
opportunities);
• Takes you out of harm’s way by exiting individual stocks or the entire
market when conditions warrant.
Risk management is not a prediction that things are going to go bad, but it is a
defense against the possibility that they might go bad. Contrary to popular
opinion, avoiding outsize losses—not hitting the occasional “home run”—is the
most important factor in beating the market.
Every risk management maneuver, itself being an investment decision, carries
its own risk. The risk in risk management is that it will make you so cautious
that you will not make as much money as you would if you accepted more risk.
For example:
• Easing into a stock position through multiple purchases—a common risk
management technique—will cost you money if the stock goes straight up after
your initial purchase. It is not money you lose, per se, but money you fail to
make by not buying the stock all at once in the first place.
• Selling a stock because of a short-term price drop will stop your losses in
the short term, but if the stock reverses itself and goes back up and beyond the
price at which you sold it, the decision to sell will cost you the profit you would
have made if you’d simply hung on to the stock.
• Diversifying will cost you money compared to what you would have
made if only you’d known which single stock in the universe was going to do
the best and just bought that.
So why practice risk management? To protect against devastating losses. In the
long run, your returns are most likely to beat the market if you avoid outsize
losses. The idea is to balance risk vs. reward opportunities in order to produce
the greatest return in the end.
Risk management techniques range from the extremely simple—like easing your
way slowly into the market—to highly complex activities utilizing sophisticated
investment products and strategies that are beyond the ken of the average
individual investor. In this regard, one often hears the term “hedging.” Hedging
is a subset of risk management. The term usually means buying (or selling)
something—like another security, an “option,” or your own stock short—which
theoretically offsets the risk of what you already own. The Sensible Stock
Investor manages risk using simpler techniques.
Why is controlling losses so important? Because it is so hard to make up for
them. Let’s look at a few examples. If you lose just 5% in a stock, it only takes
about a 5% gain to make up for it. But as the percentage of loss grows, the
percentage you must then gain—just to get back to even—grows geometrically.
A 25% loss takes a 33% gain to get back to even. A 50% loss takes a 100%
gain. Some of the dot-com high-flyers of the late 1990’s lost 90% of their
market value. What do you think it will take to get back to even? A 900% gain!
Realistically, that’s not going to happen.
So the Sensible Stock Investor avoids outsize losses in the first place. The new
book, Sensible Stock Investing, describes in detail the relatively simple
techniques that the individual investor can use to sidestep large losses—such as
not using margin, not selling short, and controlling losses with sensible sell-stops.
Remember Buffett’s Rule #2: Don’t forget Rule #1. And what was Rule #1?
Don’t lose.
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