Risk versus value matrix with pushpins and blur effect. Concept of investment risk assessment.
Porter Stansberry and Steve Sjuggerud have strong differences in their investing philosophies. There’s one thing, however, that they couldn’t agree on more.
When Porter, Steve and I sat down recently to debate when this bull market might end, it was clear that Steve still sees lots of daylight ahead while Porter is more focused on the dark clouds he sees on the horizon.
But when it comes to the importance of proper risk management, there is no daylight between them.
I couldn’t agree more.
What I’ve found though, is that most people get risk management wrong right out of the gates – with disastrous results. In fact, in all of my studies of investor behavior, I’ve found that the biggest mistake people make when investing is putting too much money in high-risk stocks and not enough money in low-risk stocks.
Risky stocks usually have exciting stories and when we hear these stories, we tend to get excited about the stocks and want to put more money into them. More money than we should.
I’ve written about this in the past, most recently here.
Putting more money into risky stocks can destroy portfolios and it usually only takes one or two oversized investments in risky stocks to do it.
One of the keys to being profitable in the stock market is to not lose too much money in any one stock. That seems simple enough… but simple doesn’t mean easy.
How can investors better manage their portfolios so their risky stocks don’t destroy them? Fortunately, I’ve found the solution. It’s called “risk parity.”
Risk parity may sound complex but it’s really quite simple. It means taking an equal amount of risk in each stock in your portfolio. It means putting less money into your risky stocks and more money in your safer, boring stocks.
The following chart is a bit hard to believe but it’s absolutely true. The black line shows the original performance of an actual investor that lost $100,400 over about an 8-year period.
The blue line shows what this same investor could have made on the exact same stocks, bought and sold at the exact same time and ONLY changing the amounts invested so that more money went into the safer stocks in the portfolio and just the right amount of money went into the high flyers.
I know that many of you have seen this chart before but you have to admit, it never fails to amaze that something so simple as changing the amounts you invest could have such a profound impact on your results. Am I right?
We’ve made it really simple in TradeStops to compare the amount of stock that can be bought using equal amounts of risk. If you’re a Premium or Lifetime subscriber you can use the Risk Rebalancer to apply equal-risk position sizes to an entire portfolio with just one click.
Today, however, I want to keep it simple and just remind us all how easy it is to apply this profound strategy on individual stocks. That can be done with any level of TradeStops account using the Position Size Calculator and the TradeStops Volatility Quotient, or VQ.
To illustrate this, we’ll take three well known stocks – Apple (AAPL), Tesla (TSLA) and the Market Vectors Junior Gold Miners ETF (GDXJ). The VQ’s on these three stocks are 17.3%, 29.4% and 43.6% respectively.
For each potential investment, we are willing to risk $1,000. In other words, we’re basically willing to lose $1,000 on each idea if we’re wrong. We’re taking an equal amount of risk on each investment.
So, how do you decide how much to invest based on how much you’re willing to risk? Just divide the amount that you’re willing to risk by the VQ of the stock.
For AAPL that’s $1,000 / .173 = $5,780.35.
For TSLA that’s $1,000 / .294 = $3,401.36.
For GDXJ that’s $1,000 / .436 = $2,293.58.
Amazingly simple, isn’t it? You’re taking equal risk on all three of these stocks and you’re putting more money into the least risky stocks and just the right amount of money into the riskier stocks.
Amazingly simple, yes, but it’s the single most amazingly impactful strategy I’ve ever developed.
That’s because successful investing is about staying in the game and not getting knocked out by even one or two painful mistakes. By investing the right amount of money in each position, you’ll give yourself the best opportunity to be a successful investor.
There’s not much that Porter and Steve agree on 100% but they both agree with me on this one. I hope you do too.
Make More, Risk Less.
Richard Smith, PhD
CEO & Founder, TradeStops