"Worrying About Risk Means You Don’t Know What You’re Doing…”That’s a pretty provocative statement about risk.Who made it? Warren Buffet. Billionaire, Professional investor, and reputedly, one of the best investors of the last century. Some even go as far as to say, “the best of all time”. Suffice to say, when Warren talks, people listen. Warren made this statement at one of his annual shareholders conferences – an event so big that it was held in a sporting stadium. But he wasn’t saying that you should go blindly into an investment. What he was suggesting, is that if you know how to manage risk, then you only ever expose yourself to the level of losses that you are comfortable handling. Consider this…How many times have you heard of someone buying shares, only to see them progressively diminish in value over a period of weeks, months or even years? Perhaps you’ve even experienced it yourself. It’s not uncommon to see an investment drop by as much as 500% over the course of a couple of years. For example AMP which sold for a high of just over $15.00 in 2001, but then dropped to a shade over $3.00 in 2003. Many investors who didn’t have an investment management strategy and bought at the top, only to sell at the bottom, were big losers. Congruent with this experience is the investor’s hope (often falsely guided) that the investment will rebound or bounce back up. And in the case of AMP, while it rebounded to a degree (back to $7.50 from almost $3.00) it’s still a far cry from the price at which many investors bought the stock.
The main reason for this “falling back on hope” is the absence of a
risk management strategy or
risk management rules. Simply put, a risk management strategy ensures
that:
David Novac, a former investment banker, active trader and one of Australia’s leading stock-market trading educators, teaches to never place more than 20% of your investment capital into a single trade or investment. And if the stock or investment drops by more than 10%, to sell, or exit out of the position. If you were to adopt this strategy, and had $100,000 in investment capital, you would never invest more than $20,000 into a single investment, and if the investment dropped in value below $18,000, you would sell the stock or exit out of the managed fund. In effect using this strategy means that you can never lose more than 2% of your entire capital on a single investment or trade. It also means that using these risk management rules you could have as few as 5 investments at any one time. Other investment analysts promote more conservative strategic management rules. For example, Dr Steve Sjuggerud, who has a PhD in finance, is a professional trader, and an investment analyst tends to adopt the strategy of using no more than 2% of available investment capital on a single investment and using a stop loss of 25%. This means that with the same $100,000 you would invest no more than $4,000 on a single investment, but the investment could drop a lot lower, in this case to $3,000, before you would sell or exit out of the position. Using this risk management rule means that you would never lose more than 1% of your capital on a single investment. But it also means that you would need to have at least 25 separate trades or investments at any one time to fully utilise your investment capital.
These are just two common and possible approaches. But the risk
management rule that you choose to adopt will be driven by 2 factors:
As a general guide, a risk management rule that allows you to only
lose 1% of your investment capital on a single trade would be considered
conservative. Increase it to 2% and you are at a
moderate level of risk. And if you were willing to lose 3% or more
on a single investment then you would move into an aggressive or high
risk category. And as you can gather, the permutations and combinations of
achieving a risk management strategy are numerous. For example
a 2% risk management rule on total investment capital of $100,000 could
be achieved in the following ways…
And of course you could have some investments with different risk
management rules. For example one investment of $20,000 with a stop loss of 20%
and 8 investments of 10,000 each with a stop loss of 20%. Don’t keep changing it too frequently. Gary Marling, a private full time trader in Brisbane who has been trading since he was 15, (he is now in his late 40’s) also confirmed this ‘secret’. He said, “What I did differently over the last 3 years to make 300%p.a was simply stick to my risk management rules. In the past I always had risk management rules but I would always break them too. But over the last 3 years I simply stuck to my rules. That’s all I did differently” So again what’s more important than which risk management rules you choose to adopt, is that you actually have and follow a risk management rule. And this is the real difference between the professional, successful investor and the amateur investor. The amateur may know when to buy, but what they don’t tend to know, is when to sell. And those that do, but don’t follow their own risk management rules, can still end up losing money because they don’t have emotional discipline. Victor Sperandeo, the trader who averaged 72%p.a over 18 years without a losing year, correlated it to people who try to lose weight. To paraphrase, he said that whilst most people have the knowledge necessary to lose weight, most who attempt to lose weight are unsuccessful because they lack emotional discipline. In other words they don’t do what they know they should do. In relation to point 2, stop losses, you should also consider implementing your stop loss as a trailing stop loss. A trailing stop moves up as your investment gains in value. For example, if you buy a stock for $10, and you set a 20% trailing stop, then you would sell when the stock falls to $8.00, or, 20% lower than $10. If, however, you buy the stock at $10, and the next day it closes at $12, your new trailing stop would be $10 – in other words 20% lower than $12. Again, with trailing stops, the discipline is what matters most. The key is to sell when you hit the trailing stop, no matter what. By following this simple strategy your investment results should start to improve immediately and dramatically. It’s one of the most important investing rules you can follow. This is commonly referred to as “cutting your losers, and letting your winners ride.” That way, you’re never stuck with a worthless investment… and the upside potential is unlimited on the ones that are doing well. The other strategy common with trailing stop losses is withdrawing or selling half of your profits if the investment doubles. This allows you to ‘play only with profits’ and achieve the most important rule of investing – return of capital. From that point on you have moved onto the second most important rule of investing – return on capital. A final note in relation to risk management is that when you’re applying risk management rules to managed funds you have to ensure that you don’t choose funds with high fees. Ideally, funds that have no entry fee and no exit fee. According to U.S researcher Plexus Group the average entry and exit fee for a managed fund is 1.6% -- 0.8% on the way in and 0.8% on the way out. Having said that, there are many funds that have no entry fees or exit fees and hence the cost to switch is virtually the same as buying and selling a stock. If there are exit fees make sure that you include that into your stop loss. For example, let’s say that you’re investing $10,000 into a fund that has no entry fee but an exit fee of 2%. Your stop loss is set at 20% or $8,000. In other words the most you are ever willing to lose on this investment is $2,000. However the point at which you would actually set your stop loss is about 18% or $8,200. Because at that point if you exited out of the investment it would cost you another 2% of the remaining balance, or $164.00, to get out of the investment.
So as you can see, the difference between the pro and the amateur
is that the professional knows that some of her investments won’t make a profit,
but she’s disciplined enough to cut her losses at a predetermined dollar value
before the investment sinks any further - where the loss could be huge.
And secondly, by taking a portion of profits and reinvesting them into a
different investment, again at a predetermined dollar value she ensures that her
profits are maximized. In other words, minimum losses, maximum profits.
So if after reading about the amazing returns possible with offshore mutual
funds you were left with the thought…”These are incredible returns, but isn’t
high yield risky?”…then perhaps this information will demonstrate to you that * Real Rate of Return – The real rate of return is calculated in the same way that offshore funds calculate their return, using the Real Rate of Return formula. It is calculated by adding the yearly returns to the initial investment and then dividing the total by the initial investment. It assumes that the initial capital remains in the fund and that profits are reinvested. All calculations are net of fees and do not account for tax considerations which may vary from person to person. Past performance is not necessarily an indicator of future performance. The top 10 offshore funds would have turned your $500,000 into $2,633,700 without a 10% stop loss, an average total return of 460%. But with a stop loss you minimize your risks and maximize your returns. If you used this approach with the top 10 Australian funds over the last 5 years using a 10% stop loss you would have risked less than 0.5% of your capital in any calendar year, but you would have made 526% over the 5 years…as you can see the risk-return ratio is miniscule and incredibly safe when you adopt a risk management strategy.
The strategies you use to manage and minimize the risks once you
have your investments are the important follow-up to the
risk minimizing due diligence you do before placing your investment.
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