Reduce Risk to Supercharge Your Stock Investments

August 2006

By Mark Kramer

Successful investing is all about the effective management of risk in your stock portfolio. Reducing risk and avoiding large losses can have a tremendous impact on the growth rate of your investment portfolio over the long term.

Your financial advisor may tell you that to be a “growth investor”, you need to increase your tolerance for risk and be willing to live with portfolio losses on the order of 30% or more when the market turns down. This is not true!

If you really want to super-charge your long term investment returns, your tolerance for risk should probably be... less not more!

Remember Billionaire investor Warren Buffet says his key to investing success is to "Never Lose Money".

The key is to understand how reducing risk and cutting losses affects the rate of growth in your portfolio… and what that means for the risk tolerance you should have. If you are a “growth investor”, then you need to understand this basic principal.

Doesn’t Growth Investing Mean Taking More Risk?

Our ideas may conflict with what you think you already know about “growth” investing. You probably know that “growth” type investments are riskier, so how can you reduce your risk tolerance and also invest in these riskier growth investments?

Too much risk will actually hurt your long-term growth prospects while reducing risk will enhance growth.

But by using new, more advanced forms of active investment management based upon market timing, a growth investor can reap the benefits of investing in growth-type investments and also keep their reduce the overall risk to their portfolio.

This new approach allows you to harness the power of compounding, capture the superior gains of growth investments and multiply profits on top of profits – accelerating the growth of your nest egg with relative safety.

If you don’t think you could learn how to apply a more advanced approach to your investing, don’t worry. There are various investment newsletters and advisory services that will simply tell you what to do. Alternatively, there are money managers you can hire that use the new, advanced techniques.

Compounding Earnings Creates the Magic

You can read entire books on how to use the “magic of compounding” to get rich. You can become a millionaire by putting away a moderate amount of savings for 30, 40 or 50 years, investing the money at some moderate level of interest rate, and reinvesting the earnings in each period.

The books always point out that the key to the “magic” is reinvestment. Rather than spend the interest you earn, reinvest the earnings back into the same investment. In each period, your earning investment balance goes up by the amount of earnings in the previous period. Because the earning balance goes up each period, you earn more interest in each successive period.

This power of multiplication will start to accelerate your portfolio growth from period to period and lead to a much larger investment balance than if you hadn’t been reinvesting.

why Reducing Risk Works

To make the connection between your risk tolerance and the power of compounding, we need to look inside the mathematics of compounding just a bit. There we will find out what really makes compounding work and it will help us understand why Reducing Risk is so important.

Losses Reduce the “Earning Balance”

What is the connection between losses and compounding? It’s simple really. When you lose money in your investment account, you reduce the earning balance (or take a giant step backwards).

This is the opposite of what happens when you reinvest your earnings.

The mathematical power behind compounding is … the steady growth of your earning balance. When you reinvest earnings, you provide a larger investment balance upon which to earn a return. And here is the key mathematically:

Reduce Risk because Size Matters-

Your returns are more sensitive to the SIZE of your earning balance than the interest rate in any given year.

If you start with $100 and lose 10%, you are left with $90. If you earn 15% in the next year, you will make back $13.50 and have an ending balance of $103.50.

Alternatively, if you started with $100 and lose 50% instead, you would have reduced your earning balance to only $50. If you then made the same 15% during the next year, you would make only $7.50, rather than $13.50 and end up with a balance of only $57.50.

Losses Destroy Principal Which Must Then Be Replaced.

Increase Your Upside With a Lower Risk Tolerance

But here is the key “math” thing to understand: the higher risk reduced your principal (or earning balance) by a greater amount which makes it harder to earn the money back and replace what you lost.

You can look at the problem this way: If you lose 10%, it will take a gain of 11.1% to get back to “break-even”. However, if you lose 50%, it will take a gain of 100% to get back to even. It is much easier to earn an 11% return than 100%.

When you lose a large percent of your portfolio … you have lost the power of compounding for multiple years and significantly reduced the long-term result you can achieve.

So the point of effective risk management is to avoid the big losses.

So what are these advanced investment methods

So how can you invest in riskier “growth” type investments while reducing the risk to your portfolio?

Active portfolio management strategies use various market timing techniques to get you in and out of different investments. Many of these methods use computerized statistical models that identify longer-term market trends. They don’t try to “crystal gaze” the future. They simply statistically identify market trends and tell you when to get in or out.

By knowing when to get out before your investment gets slammed, the active portfolio management techniques significantly reduce risk.

In effect, they allow you to include riskier “growth” type investments without having to suffer the inevitable penalty of high volatility and steep losses during “bear markets”.

A simple method of reducing risk is with stop losses. You can read more about them in our article stop losses.

To learn more about our growth investment strategies for stock market and mutual fund investing subscribe to our free strategic investment newsletter at http://www.confidentstrategies.com.

Editor's note:

One of my favorite books on methods of Reducing Risk is Van Tharp's Book Trade Your Way to Financial Freedom available from Amazon.

See Reviews by others in the next column.

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