How Small Bets Could Turn into a Fortune

Small cap investing

Welcome back to your Extreme Small-Cap Profits course.

You’re now up to Day 4 of 12.

If you missed my email yesterday, we talked about the market in general — small-caps, mid-caps and large blue chips.

We also had a look at why it’s extremely difficult to become rich investing in blue chips. And that’s because it takes a lifetime for these stocks to move.

Small-caps on the other hand are an amazing opportunity. They have far more volatility, but that’s the point.

I also showed you how you could’ve beaten the market by 749% investing in small-caps.

Today we’re going to look at how to approach small-cap investing. Specifically, we’re going to look at how to limit our losses.

Not all small-caps are worthy investments. Some could be amazing. Others you’d be completely crazy to buy.

And as you’ll learn, there are plenty of small-cap pitfalls. Some companies run out of cash before they can get products to market. Others are crippled by too much debt early on.

It’s extremely important to know how to limit your losses before you start.

That way you might only have a few losses and far more investments that could rocket up 1,000% or more.

Alright, let’s do it.

Let’s jump into Day 4.

Your crystal ball is as good as Buffett’s

Will the market rise or fall in 2018?

Institutions pay millions of dollars for an answer to this question. And why not? If they know what the market will do, they could potentially make a lot of money.

But almost every investor will tell you no one knows what the market will do year-to-year. Paying for forecasts and estimates is simply a comfort activity.

They give money managers confidence to make huge bets with money that’s not theirs. Yet even the big money knows to take forecasts with a grain of salt.

Many who’ve been in the industry for years knows that there is no one super forecaster. Check out what this Wall Street analyst had to say while working in the industry (emphasis added):

Fifteen years ago, when I was a Wall Street stock analyst, I initially assumed that there were smart people who actually knew what the market was going to do. For close to 10 years, I kept waiting to meet these people.

As I worked my way up the food chain, and gained more market experience myself, I began to realise that the smart folks I initially assumed knew what the market was going to do were wrong about the market just about as often as everyone else.

When I learned that, I assumed that I just hadn’t met the right smart people yet. So I kept working up the food chain.

And, eventually, when I became a famous stock analyst myself, I got to meet just about everybody, including some of the most legendary stock-market wizards in history.

And what I finally realised was that even these folks, as super-smart as they were, didn’t know what the market was going to do.

They were right about the market slightly more often than all the thousands and thousands of average smart people — and, importantly, they bet big when they thought the odds were very much in their favour.

But they didn’t know what the market was going to do.

Many of the most successful investors like Warren Buffett and Mohnish Pabrai acknowledge they have no business in forecasting short-term market gyrations.

But what does this have to do with small-cap investing?

Limit your losses…literally

No one has a crystal ball.

No one knows which stock will go up guaranteed.

You’re bound to have some losses from time to time.

Maybe you got a bit over enthusiastic on the stock. Maybe you thought the company was heading in one direction when it stopped and went in another.

If we know we’re bound to make losses some of the time, we can take action to reduce them as much as possible.

One way to prevent losing your entire investment, is to employ stop-loss orders. These are orders that automatically sell a stock when it hits a certain price.

For example, say you bought shares in furniture business Nick Scali Limited [ASX:NCK].

You bought the stock at $7.15 per share. Let’s say we’re also not willing to lose more than 50% of our investment.

To limit potential losses, we can set a 50% stop-loss order. Meaning our holdings will be sold automatically when Nick Scali drops to $3.57 per share (50% of our purchase price).

Most brokers will allow you to set such orders. If you’re unsure how, send your broker a quick email.

It’s not ideal to sell for a 50% loss. But it beats losing 100% of your investment.

But then, why not limit your losses to 20% or 10%?

Well, such a tight range might force you to sell on almost anything. Remember, small-cap stocks are volatile. They can easily rise or fall 10–20% over a week.

If volatility picks up, you might end up selling stocks for losses in a short amount of time.

A 50% stop-loss might be a better suggestion. It gives you a bit of room for the stock to move down in a short amount of time.

But of course, you should set a stop loss at a level you’re comfortable with. The idea is not to lose more than you’re willing to lose.

You might be your worst enemy

Another way to limit your losses is to literally only invest what you’re willing to lose.

It sounds obvious. But a lot of the time, investors throw thousands more than they should into the market.

Take John for instance.

John (not his real name) was a 31-year-old from Melbourne interviewed by the Barefoot Investor in 2011.

A few years ago he got the idea to trade CFDs (contract for difference). CFDs are financial products that mirror the movement of asset prices.

For example, a BHP Billiton Limited [ASX:BHP] CFD mirrors the price of BHP’s stock. Similarly, gold CFDs mirrors the price of gold.

Essentially, it gives investors the ability to bet on the price of assets rising or falling. What’s great about CFDs, some investors think, is their ability to use leverage.

For example, say you wanted to buy 100 BHP shares at $31 per share. Such a purchase would cost you $3,100 on the open market.

But had you bought the equivalent in CFDs, you might only have to stake 5% of the purchase — $155.

OK, back to John.

John thought, if he used a 10% stake of $10,000 in CFDs, he could potentially double his money. Meaning John would use $10,000 to buy $100,000 worth of shares.

A 10% move upwards on $100,000 would then mean John profits $10,000, doubling his money.

Of course the situation can get hairy pretty quickly.

If prices go the other way, say 10% down, John would lose everything. Worst thing was John was trading CFDs on very volatile assets. Meaning his investment could easily go up or down 10% at a moment’s notice. John stated:

I did okay at the start, but I didn’t really know what I was doing. For me, all too often I’d get this kind of overriding, heart-racing moment where I thought things are going to turn around

So I’d go deeper, and deeper…while the market kept going the wrong way. Too many times I woke up to find out I’d received an automated margin call email (to top up his trading account because of losses) from my CFD provider.

How many times did John have to top up his trading account?

Around 25-times. When all was said and done, John was down about $250,000!

Clearly John was betting far more than he was willing to lose, and got burnt in the process. I feel terrible for people like John.

But it’s my hope that you don’t end up like them, and limit your losses.

Small bets turn into huge profits

The biggest advantage to small-cap stocks is their returns.

You don’t have to put your life savings into a single investment to make a lot of money.

You might only invest $5,000 to start with. Doubling that would be a nice bit of change in your back pocket.

But imagine if you grabbed a 10-bagger (1,000%), which is entirely possible investing in small-caps.

Such a return would turn $5,000 into $50,000. It would be enough to take a trip around the world in style.

Say you invested $10,000 netting the same return. With your $100,000 you’d have more than enough to start searching the property market for a new home.

There are vast possibilities investing in small-caps.

That wraps it up for Day 4.

In day 5 I’m going to show you where to look to find the best small-cap opportunities and what a typical 10-bagger looks like.

See you then.

Cheers,

Härje Ronngard,
Editor, Money Morning

Harje Ronngard

Harje Ronngard

Harje Ronngard is the lead Editor at Money Morning. With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.

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