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​Managing Your Risk Investing in Stocks - Part 1

How to manage the risk of investing in stocks

Investing in stocks can be scary.

Thinking about the market crashes of 2001-02 and 2008 is enough to keep you up at night. 

But it doesn't have to be that way.

More...

Investing in stocks is an important part of wealth building. You shouldn't avoid it because you're scared.

Most investing disasters can be avoided with some simple risk management rules.

That's what I want you to get out of these lessons. More confidence to invest because you have a simple plan and know what to do.

Video Version of Part 1

If you prefer to watch a video version of this lesson, it's below.

Or if you prefer to read, just keeping going...​

What you'll learn in Part 1

In Part 1 I'm going to introduce you to the 2 critical factors of stock investing risk management.

Think of them as the building blocks of your investment risk management plan.

In the later lessons we'll put these 2 factors together and I'll show you how to build a risk managed portfolio. Then I'll show you how to adjust and manage it as your investments move.

Before I get into the 2 factors, let's address two myths about investing in stocks...

Two Myths About Stock Investing

Wall Street is a factory of misinformation. Confusion and fear are the lifeblood of the creators of fancy financial products.

But at it's core, investing is really pretty simple.

So, to make sure you go into these lessons with the right mindset, I want to dispel two investing myths:

Myth #1: You have to know the future

Stock investing - you don't need to know the future.

Prediction is hard, especially about the future. (Yogi Berra)

I know this is going to surprise you, but it's impossible to know the future.

I'm not saying you can't have some reasonable expectation about things. But you have to understand that it's just a guess. A hypothesis.

Even if it comes true, it's not because of knowing. It's just probability, chance, or even luck. Not actual knowledge of the future.

If someone tells you they know for sure where an investment or the market is going, hold on to your wallet...​

Myth #2: You have to be a genius

Investing is hard enough without being complicated. Keep investing simple.

You don't need to be a genius to be a good investor.

Being a good stock investor is not about understanding chaos theory, macro economic models or having a PHD in statistical analysis.

No, it's about having goals, commitment and confidence.​

And confidence comes from having a simple, actionable plan that you understand. Yes, it really is that simple.

Alright, now that we're on the same page, let's start building that plan!​

Critical Factor 1: "How much?"

Imagine I showed you a stock chart.

Over a two year period the stock went from $60 a share to $150 a share. And then it quickly went back down to $70 a share.

GMCR our example stock for investing risk management

Is that a risky stock?

I think most people (me included) would answer "Yes".

But is there something simple we could change that might have us answer "No, not really"? Without changing the stock.

If you had a $1,000,000 portfolio and this stock made up 100%, would that be risky?

Absolutely. Completely off-the-charts risky.​

But if this stock only made up 0.05%, or $500 of your total portfolio, is that stock still risky?

I would say "No, not really".

Volatile, yes, but not risky. You could lose your entire investment in this stock and I bet you'd be OK. Maybe not happy, but not devastated.​

So the first of the two factors is "How Much?".

How much you have of an investment will change the amount of risk involved.​ How much will change the impact of that stock.

In Wall Street speak this is know as "position sizing". But it just means "How Much?".​

Real World Example of "How Much?"

You decide that running will be good for your health. (like deciding a stock is good for your portfolio)

Exercise and investing in stocks.

If you run one time and quit, it will have little to no effect on your health.

But if you run for 1 hour every day for 20 years it will have a huge impact on your health.​

You didn't change your choice. You only changed the frequency. The "how much".

But that made all the difference in the result.​​

"How Much?" is the first of the critical factors for stock investing risk management.​

Critical Factor 2: "The Exit"

We have the first critical factor, "How Much?". Now we'll move on to the second.

Let's go back to our stock chart.

Pretend we are the unluckiest investors in the world and decide to buy this stock right at the top, around $150 a share.​

Buying a stock at the top

Unfortunately this happens sometimes. We never know where on that chart we're buying. (see Myth #1 above)​

Because we already knew about Factor 1, we were smart and only invested a small percentage of our portfolio. Good job.

But now we're sitting with a 50%+ loss in this stock (from $150 down to $70).

That doesn't feel good.

Not to mention the psychological impact that has on our investing going forward. (But that 's for another post...)

Is there a way to make this loss more reasonable besides just "How Much?" we buy.

Sure. We can decide to sell the stock if it goes down 20% or more.

No questions asked. We just exit if it reaches that point.

So if we bought at $150, we'd sell if it dropped to $120 or below.
($150 x 20% = $30, $150 - $30 = $120)​

​So now you have a 20% loss in the stock. Again, you're not happy. But it's better than a 50%+ loss.

Note: This 20% loss point is arbitrary. In future lessons I'll show you exactly how I decide what this point is for each stock.

Now we know the second critical factor, "The Exit".

This is the point where you'll pull the plug and get out.

In Wall Street speak this is know as a "stop loss point". But it just means "The Exit".​

Real World Example of "The Exit"

Uncertainty leads to fear. And fear can keep us from doing things we need to do.

Uncertainty in driving and investing.

Most people drive everyday.

But it's incredibly uncertain each time.​

What if there's traffic? What if the lights aren't working? What's around that next corner?

With all this uncertainty, why do we feel so comfortable driving?

Because we have simple controls and some basic rules to reduce our risk.​

Traffic ahead? Hit the brakes and slow down.

Road turns? We turn the steering wheel to stay in our lane.

Found out you're going the wrong direction? Pull over and stop.​

The steering wheel and the brakes are like "How Much?" and "The Exit".

Simple ways to control our risk...​

"The Exit" is the second of the critical factors for stock investing risk management.​

Summary of Part 1

Good work!

You now have the two critical factors for building a risk managed portfolio of stocks. Pretty simple so far, right?

Here's a quick summary of what we learned:​

  • Investing is important. You shouldn't avoid it out of fear.
  • Confidence comes from having a simple, actionable plan.
  • You don't need to know the future to be a good investor.
  • You don't need to be a genius to be a good investor.
  • Critical Factor #1: "How Much?" - The amount you own of a stock will change the amount of risk.
  • Critical Factor #2: "The Exit" - You can limit the risk of a stock by having a pre-defined point where you pull the plug.

That's all for this lesson.

In the next lesson we'll put the Two Critical Factors together. We'll also learn how to add more stocks while still managing our risk.​

Let me know if you have any questions or ideas in the comments below!

Thanks,
Tommy Sikes​

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