Risk Diversification Stops
Risk, Size of Positions, diversification, and Stop Losses
It takes self-control for a new trader or investor to strictly limit the size of his positions, but self-control is necessary for long-term survival. When you have the best idea you have ever had, do not try to make the killing you just know you could make if you put everything in that one idea. When a person is excited about the story of a stock, he tends to be blind to its risks. Also, he tends not to have a strategy for selling. Why should he? After all, he will be able to sell for five or maybe ten times the current price in a year or two..
The problem with this line of thinking is that the risks are real and they can be devastating. For example, LA Gear was one of the hottest stories on the street. Those who put all their money in the stock now have nothing. The stock became worthless quickly. Genentech was selling for more than $250 when it plummeted to $8.02. CMGI was once priced at $163.50 before it collapsed to about .28 a share. JDS Uniphase went from $153.42 to $1.58. There are many other stocks like these and they all had a great story. The bottom line is that any stock can have a similar drop. Even the bluest of blue chips can plunge. The mighty IBM quickly fell over 76% from its high in 1999. To us, riding a stock down when it is headed for oblivion is assuming a great deal of risk.
It is part of human nature to go too far with an idea. That is why we will always have markets that surge till they are way overheated followed by a bust that is far too excessive and then another boom, and so on. Any stock that is rising so rapidly that it gets your attention has probably caught the attention of many others. That means excess is almost inevitable, because a rapidly rising price feeds on itself until the price becomes too absurd even for the “believers.” A trader or investor who survives in the market for a long time with assets intact is a person who pays attention to risk. Those who do not respect the dangers of the market will eventually discover that the market has ways of enforcing respect.
Never think that a particular deal is a “once in a lifetime deal.” Remember that the marketplace is full of and nurtures “once in a lifetime deals.” There will be others after the current one is only a vague memory. Therefore, limit how much of your portfolio is exposed to any one idea. Yes, doing that will also limit your gain if the idea actually bears fruit. However, our experience and research at stockdisciplines.com tell us that the most successful traders are those who focus on limiting risk and not those who focus on capturing big gains. They do commit money to stocks and various securities other than debt instruments because that is generally where the greatest opportunities for capital appreciation are. However, once having done that, they focus on controlling the risk.
You can control risk by allowing yourself to invest no more than 10% to 15% in any single idea. More specifically, divide your portfolio into 10 positions if you are a beginner and maybe 7 positions if you have traded successfully for a few years. Think of these “positions” as baskets or containers into which you will place your investments. No more than one position (container) should be designated for any given stock. However all positions can be allocated to cash. In other words a 10-position portfolio can have 3 stock investments and 7 cash investments. Diversifying your portfolio is the first step toward risk control. The second step is to use stop losses to reduce risk further. Set your stop losses so that no position can damage your overall portfolio more than 1%.
If you cannot control your greed for gain, just walk away. It is better to let a wonderful idea go than to trade or invest without controlling your risk. There will be dozens of wonderful ideas worthy of a place in your portfolio. However, they will never find a place there if the portfolio has passed into oblivion because you did not protect it against excessive risk.