How Do I Plan for Investment Risk?

Investment risk is a fact of life. Without risk, there would be no reward. The important thing is to know how to plan for it.

Since I was a sophomore in college, my passion has been the stock market—learning its history, finding what methods work and don’t work, discovering new indicators, hearing other people’s points of view—you name it, I love it.

What I love most of all is the challenge. To put it plainly, making money in stocks isn’t easy. The main reason for that is because the market is a contrary beast; it rises when most people think it will fall (climbing the wall of worry), it drops when most people believe it will rise (sliding down the slope of hope), and individual stocks can gap up on bad news or down on good news. In other words, the market often does exactly the opposite of what makes sense.

That’s why successful investors—the ones who’ve been investing and churning out solid returns for years—have a deep respect for, and are humble toward, the markets. Usually you hear the younger stock-pickers say things like “I think this will double in two months!  It’s an amazing company!” while the older, wiser veterans often claim that, “Maybe if such-and-such goes well, the stock will advance for a few weeks.” Less enthusiastic?  Maybe.  But also more humble, realizing that anything is possible in the market.

(Going along with this is the old Wall Street saying: “There are old traders, and there are bold traders, but there are no old, bold traders.”)

Which leads me to Mr. Kerveil, the infamous trader at Societe General who lost his bank billions of dollars. Whatever the reason, he decided to prove he was a great trader to his bosses. And how did he do this? By tossing caution to the wind and making huge bets in the futures markets (which are tremendously leveraged). And … he succeeded! In fact, he had traded his way to mind-boggling profits by the end of 2007, because of his foresight and big bets.

However, this is where Kerveil’s lack of perspective got him in trouble. Did he think that, maybe, he could have a bad spell after a tremendous run? Evidently not—the game appeared easy to him. And in just a few weeks, this mid-level trader lost everything he had made and them some. He ignored investment risk, failing to account for it, and in the end, it burned him.

The moral of the story: Successful investors always consider investment risk when analyzing their portfolio, adhering to rules like cutting losses short (if you’re into growth stocks) or diversification (value stocks). I constantly talk to investors who fail to think of the downside, plowing a huge percentage of their portfolios into a few stocks … and then failing to cut the loss short if things go amiss.

While these investors don’t lose billions of dollars, their portfolios get crushed during even intermediate-term market corrections, never mind true bear markets, which can literally wipe out 50% to 80% of their savings. So remember, even in the best of times, you want to consider how much of your hard-earned money you have at risk, and how you’ll handle your stocks should they head south.

Investment risk, however, is not all bad. Without it, in fact, there would be no profits! But, just as there are too many investors who ignore investment risk, there are nearly as many who fear it far too much.

These are the people who, after witnessing severe volatility (and, usually, losses) by the market and individual stocks, conclude the game is rigged or something of the sort, and decide to effectively stick their head in the sand and buy just tiny amounts of low-volatility stocks. The result: guaranteed mediocre returns.

My point is that investment risk is neither 100% good nor totally evil—it’s a necessary part of investing, so the key is to manage and take advantage of it in your own dealings.  Really, this is what the entire investing ballgame comes down to; most investors can find out which stocks are leading the way higher (or lower), but the difference between good returns and great returns comes down to how you handle those stocks … i.e., how you handle risk.

Personally, I tend to run a fairly aggressive portfolio—I generally don’t own more than 6 to 8 stocks at any one time. So, obviously, I’m taking on plenty of risk … my goal is controlling it in a prudent fashion. Here’s a way to do that.

First, you should pre-define the maximum loss you’re willing to take on each trade. Let’s say you have a $50,000 account. You might decide to risk 1% of your portfolio for every stock you buy; that way, even if you lose on five consecutive trades, your overall portfolio would only be down 5%. In this scenario, 1% of the account is $500 ($50,000 X .01).

Knowing that figure, you can then devise a loss limit on any stock you buy. If you purchase $10,000 of a stock, you’d set a 5% loss limit (because 5% of $10,000 is $500). If you instead buy $5,000 of a stock, you could have a 10% loss limit. And so on.

From all I’ve read, the best traders generally risk no more than 2% of their overall account per trade, and usually, the risk is more like 1% or sometimes less. So, take a hard look at your portfolio and think about what type of risk you want to take on. There is no right or wrong answer, but thinking about this topic ahead of time is like formulating a game plan before a big game—you’re more likely to get off to a good start, and you’ll be able to adjust (if need be) more easily, leading to better results.

Comments