|
Copyright 2006 DVK Group, Inc.
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 entail 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 overall.
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. But the Sensible Stock Investor can manage 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 gain back—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. Remember Buffett’s Rule #2: Don’t forget Rule #1. And what was Rule #1? Don’t lose.
If you would like to learn about a comprehensive stock investment approach that that uses the same strategies reflected in this article, please consider purchasing ''Sensible Stock Investing: How to Pick, Value, and Manage Stocks.'' This new book 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. For more information, book excerpts, an author biography, etc., visit www.SensibleStocks.com
|
|
|
|
