| Portfolio management is largely about | | | | sold it, the decision to sell will cost you |
| managing risk. Warren Buffett said, ''The | | | | the profit you would have made if youd simply |
| first rule is not to lose. The second rule is | | | | hung on to the stock. |
| not to forget the first rule.'' | | | | |
| | | | Diversifying will cost you money compared to |
| Managing risk means doing things that | | | | what you would have made if only youd known |
| safeguard your money from the possibility | | | | which single stock in the universe was going |
| that any investment decision may be wrong. | | | | to do the best and just bought that. |
| Therefore, risk management includes any | | | | |
| practice that: | | | | So why practice risk management? To protect |
| | | | against devastating losses. In the long run, |
| Lowers the inherent risk in investing in | | | | your returns are most likely to beat the |
| stocksrecognizing that all stock market | | | | market if you avoid outsize losses. The idea |
| transactions entail some risk; | | | | is to balance risk vs. reward opportunities |
| | | | in order to produce the greatest return |
| Increases the probability that your stock | | | | overall. |
| investments will profit (or, stated another | | | | |
| way, lowers the risk that you will miss out | | | | Risk management techniques range from the |
| on making money from good opportunities); | | | | extremely simplelike easing your way slowly |
| | | | into the marketto highly complex activities |
| Takes you out of harms way by exiting | | | | utilizing sophisticated investment products |
| individual stocks or the entire market when | | | | and strategies that are beyond the ken of the |
| conditions warrant. | | | | average individual investor. In this regard, |
| | | | one often hears the term ''hedging.'' Hedging |
| Risk management is not a prediction that | | | | is a subset of risk management. The term |
| things are going to go bad, but it is a | | | | usually means buying (or selling) |
| defense against the possibility that they | | | | somethinglike another security, an option, or |
| might go bad. Contrary to popular opinion, | | | | your own stock shortwhich theoretically |
| avoiding outsize lossesnot hitting the | | | | offsets the risk of what you already own. But |
| occasional ''home run''is the most important | | | | the Sensible Stock Investor can manage risk |
| factor in beating the market. | | | | using simpler techniques. |
| | | | |
| Every risk management maneuver, itself being | | | | Why is controlling losses so important? |
| an investment decision, carries its own risk. | | | | Because it is so hard to make up for them. |
| The risk in risk management is that it will | | | | Lets look at a few examples. If you lose just |
| make you so cautious that you will not make | | | | 5% in a stock, it only takes about a 5% gain |
| as much money as you would if you accepted | | | | to make up for it. But as the percentage of |
| more risk. For example: | | | | loss grows, the percentage you must gain |
| | | | backjust to get back to evengrows |
| Easing into a stock position through multiple | | | | geometrically. A 25% loss takes a 33% gain to |
| purchasesa common risk management | | | | get back to even. A 50% loss takes a 100% |
| techniquewill cost you money if the stock | | | | gain. Some of the dot-com high-flyers of the |
| goes straight up after your initial purchase. | | | | late 1990s lost 90% of their market value. |
| It is not money you lose, per se, but money | | | | What do you think it will take to get back to |
| you fail to make by not buying the stock all | | | | even? A 900% gain! Realistically, thats not |
| at once in the first place. | | | | going to happen. |
| | | | |
| Selling a stock because of a short-term price | | | | So the Sensible Stock Investor avoids outsize |
| drop will stop your losses in the short term, | | | | losses in the first place. Remember Buffetts |
| but if the stock reverses itself and goes | | | | Rule #2: Dont forget Rule #1. And what was |
| back up and beyond the price at which you | | | | Rule #1? Dont lose. |