Risk Management — Your Key to Successful Investing

Investing is risky, no matter how you do it. And speculative resource investing, my speciality, is no exception! But with the right risk management tools, you can help to protect yourself from the worst losses, and bounce back in the markets.

My favourite book about risk is Reminiscences of a Stock Operator, by Jesse Livermore. It’s a story on Livermore’s experiences, documenting multiple lessons learnt along the way.

I try to read the book once a year. If you haven’t read it, I strongly recommend doing so. Or, if you’re happy to break the bank, pay $1 on your Amazon Kindle.

Livermore always played with big swings in the markets (something you shouldn’t do if you’re just starting off), making numerous fortunes. He amassed over US$100 million shorting the 1929 stock market crash. That’s equivalent to about US$1.38 billion today.

As you might know, Livermore wasn’t always right. He went ‘flat broke’ (as he called it) numerous times during his life. Of course, his loss was never a total loss. Otherwise, he wouldn’t have been able to make a comeback as frequently as he did.

Livermore committed suicide in November 1940. The gentleman went broke and gave up. He didn’t see a point in making the losses back, as he had done so many times over his trading career. In his own eyes, he was a total failure.

An investing lesson worth knowing

Here’s a noteworthy quote from Reminiscences of a Stock Operator:

My losses have taught me that I must not begin to advance until I am sure I shall not have to retreat. But if I cannot advance I do not move at all.

In other words, learning from your losses is the most important part of the investment business. Livermore made money when he followed his rules. But he lost a fortune when he let them slip.

In reality, few investors actually learn from their losses. Livermore often ignored them himself!

The biggest losses are emotionally challenging — you can trust me on that one. It can be hard to come back from them, and gain the confidence to recommence trading. The best way to avoid big losses is by sticking to these investment rules:

  1. Pay as little as possible for each trade.
  2. Use stop-losses — get out of a trade that’s losing you money before it loses all your money.
  3. Sell a company when the original investment thesis doesn’t work out.
  4. Remember rules one, two and three.

But what, I hear you ask, are stop losses?

A stop loss (also known as a stop loss order or a stop order) is an order you place with your broker to sell your position if the share price drops below a certain level. For instance, if the share price of a company was trading at 90 cents, you could place a stop order at 80 cents.

This means if the share price falls to 80 cents your broker will sell you out of the position for around that price. But be aware, if the shares ‘gapped’ lower to say, 75 cents, then you order would be executed at that price. Your order may not get filled at the level at which you place your stop.

If you’ve never placed a stop order with a broker, our advice is to give them a call to ask them about it. Sometimes different brokers have different rules and procedures over how these trades are handled, so it’s best to check with them first.

If you use stop losses, and follow the rules above, you should be able to stay solvent following any losses and go on to increase your wealth…hopefully quickly, after backing a few winners!

Note that I always recommend spreading your risk across multiple stocks. Also, never invest more than you can afford to lose.

Finally, have some ‘dry powder’ available for the best opportunities. The stock market will always throw you unexpected opportunities when you least expect it. You want to have some cash on hand to capture those opportunities.

The stock market will also throw unexpected challenges your way. If you can’t take a small loss, you’re finished from the start. Losses are part of the business.

Stock trading doesn’t need to be difficult. Keep it simple. Admit when you’re wrong by taking those smaller losses, then move on to the next stock opportunity.

Jason Stevenson,
Resources Analyst, Money Morning

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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