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