Reduce Risk to Supercharge Your Stock Investments

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 founder Mark Kramer has over 24 years of experience in the Financial Services industry. He was most recently a licensed Registered Representative with a predecessor firm of JP Morgan Chase. Mark intends to share his investment knowledge and research to help investors make smarter investment choices in the stock market and mutual funds.

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.

Trade Your Way to Financial Freedom

by Van Tharpe

An expert in trading psychology, Tharp quickly covers why most novice traders fail due to psychological problems trading and unrealistic expectations of the market. He advocates that an individual rationally lay out objectives for trading and design their own system, using whatever techniques work best for them, to meet their goals. Tharp goes on to describe the components of a trading system and how to objectively judge between them. He stresses the importance of money management and position sizing; two areas where traders should spend much of their time but often ignore. Just to be clear, there are no trading techniques at all in this book: no technical analysis signals, no material on how to pick stocks or futures, nothing like that - just how to build a system and overcome some of the psychological barriers to successful trading.

As a professional commodities trader, I believe that a thorough reading of Tharp's work will give a novice trader the benefit of years of hard-earned wisdom. It can take years of mistakes and losing money before internalizing the lessons Tharp gives out for a relatively extremely cheap price! It is very important to think about position sizing and money management. It is equally important to have a technique that can be objectively evaluated rather than trading randomly. No matter how you choose to approach the markets, whether by reading technical charts, fundamental reports, or quantitative models, Tharp's advice is excellent.

Reviewer: Doji Star

Aspiring traders need this one

An outstanding book in the trading literature that is both revealing and inspirational. Dr. Tharp understands both human psychology and trading systems, and more importantly how necessary it is to meld the two in order to achieve success in one of the most challenging endeavors humans can undertake.

What really makes this book unique is its treatment of the subject of proper position sizing as an aspect of risk and position management. This is probably THE most important concept to grasp and properly utilize in order to speculate in markets and be consistently profitable. Yet this book contains the only treatment of the subject I have ever seen after having read more than 30 trading books.

For example - if you are daytrading stocks and always take on a 2000 share position regardless of the price and daily range of the stock, you are demonstrating reckless abandonment of this critical element to successful trading. Perhaps that alone is what is holding you back.

Lots of books mention that position management and exits are far more important than entries, but this book really gets into the issue and attempts to show the reader why. The author holds firm his conviction that a good trader can be profitable from random entries to exemplify this point. Imagine how well you should be able to do if you are good at entries as well!

Ultimately we all arrive at some sort of methodology that we use in trading, even those of us who consider ourselves to be discretionary traders. Van Tharp's excellent book really helps one in developing his methods by prioritizing the most important elements and stressing the necessity of working a method that is customized to your own temperament and personality. If you are an aspiring trader, buy it. Read it, study it, get the concepts taught firmly into your brain and keep this book on your shelf permanently.

Reviewer: Andrew P. Kasch

Far Exceeded Expectations

Detailed, thought provoking, and original. Tharp exposes common mistakes and misconceptions that often trip up the average trader. I found this book to be an incredible resource, helping me to identify my strengths and weaknesses and improve my overall approach to trading.

J. Daniels

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