Goldman Sachs is out with a report saying that the economic downturn will be four times worse than the Global Financial Crisis and that the U.S. will see a decline that could be “unprecedented.”
I know that’s hard to imagine, given the rally that’s underway as I type, but you’d be wise to prepare for the possibility.
The only thing standing between your portfolio and catastrophic loss is your own caution and proper risk management.
Even as you chase profits!
Today we’re going to talk about a simple, easy to use tool that can make all the difference in the world when it comes to adding tens of thousands of dollars or even millions of dollars to your bottom line by avoiding portfolio-killing losses.
Here’s how you can control risk BEFORE there’s another reversal
Risk management is something a lot of folks think they have handled, but very few investors actually do… until it’s too late.
I don’t ever want you to be in that position.
The time to control risk is BEFORE you buy using a simple, easy to implement Total Wealth Tactic called “position sizing.”
If you’ve never heard the term, don’t worry. You’re not alone. In my nearly 40 years in the industry, I’ve run across a lot of seasoned professionals who have a hard time explaining exactly what position sizing is, let alone why it can lead to bigger profits.
Yet the concept is actually really simple – controlling the amount of money you place in each trade can lead to bigger profits and mitigate the risk of a catastrophic loss.
To see what I mean, consider this anecdote from trading psychologist Dr. Van Tharp who has studied position sizing extensively over the years:
“We’ve done many simulated games in which everyone gets the same trades. At the end of the simulation, 100 different people will have 100 different final equities. And after 50 trades, we’ve seen final equities that range from bankrupt to $13 million – yet everyone started with $100,000, and they all got the same trades. Position sizing and individual psychology were the only two factors involved – which shows just how important position sizing really is.”
While there are a lot of things to like about position sizing, there are two elements I find particularly compelling:
- You never have to worry about a large chunk of your capital getting vaporized; and,
- You implement this risk management tool before you invest a single penny which automatically boosts your probability of profit.
It’s one of the single most important concepts any investor can learn… or relearn.
Many investors start out by swearing to themselves that they won’t risk a penny more than a certain amount on any trade. That there’s a line they won’t cross, no matter how glittering of an opportunity they face or how caught up in the moment they are.
The major problem with this is that very few investors see the plan the entire way through. Many get positively clobbered when the markets sell off hard like they did just this past month.
In theory, those same investors apportion no more than 10% (or whatever the figure they deem appropriate) to the risky stocks that they hope will become home runs.
Admittedly, it’s a difficult commitment to stick to at times. Many an investor has made an exception, just for this one stock, and gotten burned.
Other times, an investor might stay true to their commitment to never expose more than 15% of her portfolio to riskier stocks. But they put 10% of their capital into an exciting company that’s nonetheless a flash in the pan, and takes a big hit to her portfolio – despite staying true to their original risk guidelines.
The worst offenders by far though are the investors who bet the ranch on a stock, even one they’ve thoroughly researched, and who end up with nothing when the markets have other ideas. And while that’s sad to see, many millions of investors hurt themselves with minor-seeming positioning mistakes that their portfolios nonetheless take months or even years to recover from.
What these investors don’t understand is the science of managing and controlling risk, eliminating it where possible. And that brings us back to position sizing.
Position sizing is the science of cutting risk in your portfolio down to the bone. It answers the question “How big should I make my position for any one trade?”
Many investors think they have this covered with trailing stops that take them out of an investment when some predetermined limit is hit. Usually, it’s a percentage loss or a dollar figure.
Position sizing is different. It’s about determining how much of something you can buy for maximum profits or even if you can afford to buy in the first place.