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​Managing Your Risk Investing in Stocks - Part 2

How to manage risk - part 2

"Stocks are too aggressive for me. I'll just invest in mutual funds." she told me.

I was thinking "What do think is IN mutual funds?" (hint: stocks)

She thought mutual funds and stocks were totally different investments.

More...

She was scared of one, but fine with the other. 

Nothing wrong with mutual funds, but don't expect to do much differently than the overall market. And I mean going up and down.

I'm a believer in owning stocks directly. You avoid some unnecessary expense (the fund expense) and you can get more bang on the upside and can still protect your money when things get crazy.

That is, if you control your risk...​

Let's continue what we started in Part 1 and get into some good stuff.

Ready?​

Video Version of Part 2

If you prefer to watch a video version of this lesson, it's here:

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

What you'll learn in Part 2

In Part 2 we'll do more with the 2 critical factors of stock investing. You'll see how using them together works better than only using one.

It's like diet and exercise. Improving either one is good, but doing both is better.

I hope you like it.

But first let me explain something important...​

Albert Einstein and Risk

Remember physics class in high school?

There's a thing called The Law of the Conservation of Energy. It says:

Energy is a property of objects which can be transferred to other objects or converted into different forms, but cannot be created or destroyed.

​Risk is the same. It's a property of investing that can change forms, but is always there.

Put your money in the bank?

Yes you avoided market volatility risk, but you change it to inflation risk. And inflation is way more consistent and dangerous over time.

And the biggest risk I see people taking?

It's that you get to the end of your life and realize you missed all the amazing adventures, travel and experiences life has to offer. All because you chose safety and security and modest comfort.​

I call it life risk.

Picture of St. John's beach.

That's not how life should be lived.

Take risks. Manage them. Don't avoid them.​

Life was meant to be bland, boring and completely forgettable.

- No one. Ever.

Go out and live a great story...

All right, back to Part 2.

Combining the Two Factors

Last lesson we learned about the two critical factors of managing stock investing risk. They are:

  1. "How Much" and
  2. "The Exit"​

By using only the first, "How Much", you'll see how you can control the amount of money you risk.

But by combining both factors, you'll learn how you can control risk AND increase your potential returns at the same time.​

Q: How much money should I risk?

For a single stock, most investors are on the extremes. They'll either have 40% of their entire portfolio in a stock (way too much!) or one stock makes up 0.3% of their account (like in a mutual fund).

I like to take between 1% - 3% of risk per stock.

Anything above 3% for a single stock and I'd consider you an aggressive "gunslinger".

Just so you know... :)​

We'll use the same example stock as last time.

And we'll pretend we're the unluckiest investor in the world and buy right near the top (~ $150 per share).​

Buying a stock at the top

We'll risk 1% of our $1,000,000 portfolio on this stock. So that's a total of $10,000.

Using only "How Much" to control our risk, the most we can own of this stock is $10,000. That's because without an exit point, we're assuming we'd ride this stock down to zero (or at least $70 where it ends on the chart).

And that's good risk management.

But you're also looking for good returns.

So what if you're the luckiest investor in the world and happen to buy at $60 per share? (It does happen)

This stock then went up 150% in about a year ($60 to $150). That's an incredible return!

However, since you only own $10,000 (to control risk), your 150% only adds $15,000 to the total portfolio. That's only 1.5%. For owning an amazing stock a year.

Not the impact you want from a stock that goes up that much.

So how do we both control our risk, but also get more bang for our buck?

Exactly, combine the two factors.

"How Much?" + "The Exit"

Let's agree that we'll exit this stock if it goes down 20% or more.

If we buy at $150 per share, that means we'll exit at $120 or below. That's "The Exit".

$150 x 20% = $30
$150 - $30 = $120
$120 is "The Exit"

We already know our risk on this stock is $10,000 or 1%.

By using some simple math, we can figure out our "How Much?".​

For a stock, "How Much?" means how many shares. If we know how much risk per share and our total risk, it's simple division:​

$30 of risk per share (see above)
$10,000 of total risk
$10,000 / $30 = 333.33 shares

So if we buy 333.33 shares of this stock at $150 per share, that's a total of $50,000 in this stock. Or 5% of the portfolio.

Let's test it out now.

First, we're unlucky and buy at $150.

The stock goes down to $120. We exit.

We lose $10,000. Not happy, but good risk management at 1%.

Next, we're super lucky. We buy at $60. The stock goes to​ $150.

Now our $50,000 turns into $125,000​. That's an additional $75,000.

Or 7.5% of our portfolio. Boom.​

Invest to control risk and have upside potential

Now we're talking.

Being Wrong and Making Money

Risking 1% to make 7.5% is awesome. But it's impossible to know which stock will return 150%.

But think about this.

Say you buy 5 stocks. You risk 1% on each one. Four of them are duds and you lose your 1%.

But the fifth stock is our example stock from above.

That means you can be wrong on 4 out of 5 stocks and still make money.

Here's the math:

Pick 5 stocks, 4 are losers
4 x 1% = 4% loss
1 makes 7.5%
7.5% - 4% = 3.5% return

​You could be wrong 80% of the time and still make money.

That takes a lot of pressure off of picking the "right" stocks and the "right" time.​

Most investors are attracted to ads for stock picking services where they say they're right 90% of the time.

But some of the best, most profitable investors of all time have win percentages in the 30% to 50% range. It's just that when they lose, they lose small. But when they win, it's massive.​

That's why they're some of the wealthiest people in the history of the world.​

Don't fall into the trap that you need to be right to make money. You don't.

You just need to control your risk.

Summary of Part 2

Awesome. Another lesson down.

You now know the simple math behind controlling your risk while still having upside potential. You learned to combine "How Much?" and "The Exit".

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

  • Risk is constant, it just changes forms.
  • Inflation risk is more consistent and dangerous than market risk.
  • The biggest risk is not living an amazing life out of fear.
  • Risk no more than 1% to 3% per stock
  • Combining the two factors let's you control risk while having upside potential
  • Using risk management, you can be wrong often and still make money.

That's all for lesson 2.

In the next lesson we'll discuss what portfolio "heat" is. We'll also get into more detail about setting our exit point.​ Finally we'll discuss how to adjust things as stocks move up and down.

Thanks for reading/watching...​

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

Thanks,
Tommy Sikes​

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