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It is possible to minimise risk. “Caveat emptor’ or buyer beware is a legal perspective but there is also a need to be a little street smart in applying some basic “risk management” steps. These will appear to be obvious and be of “common sense” but so many investors fail to apply them – in the main because of poor discipline.
One of the key financial planning tenets is “don’t put all your eggs in one basket” This holds true at so many levels:
The one-third principle. It is well accepted amongst the Financial Adviser fraternity that you should have a spread of wealth – one third in property, one third in equities and one third in cash. Some argue that the third in property can include the family home, but others would argue that the one third should be an investment property. I believe it is unrealistic to expect that you should not invest in equities until you have an investment property.
The one-third principle also needs to be applied in a practical manner in that if you have already retired you may want more than one third in cash – maybe as much 60-70% depending on your age and life expectancy – in case there is a stock market catastrophe. In fact many managed funds are holding well in excess of 50% in cash at the moment.
Many may regret in hindsight that they were not fully invested in equites over the last four months – If you were fully invested then you have to consider yourself not only extremely lucky but also a bit of a gambler and that the cards may not always play all your way in future.
I have written before about how one might judicially spread your available funds in the stockmarket – according to sectors etc., One should also consider what portion of funds you should make available for derivative markets.
The thought of derivative markets frightens most people and that I can understand. I am however an advocate for understanding the derivative markets, as they can also be a clever avenue for hedging – just like the professionals do. You must give yourself time to learn about derivatives in their various forms and even use some play money to get a feel of how these markets operate.
I would caution putting all your investment monies into derivatives unless you are very experienced.
One approach that must be avoided under all circumstances is to do a course, throw in your full time job in the belief that you can completely make a living from trading from a standing start. Yes it is possible to make a living by trading full time, but you need to assess whether it is a practical goal for you and whether this is the right time in your life to do this. If it is for you, then there are sequential steps that must be completed. These steps include proper training and easing yourself in to it and when you are set, then yes by all means take the big step.
It is hard to know how much capital individual investors are investing in the markets at any one time. What I do know is that it is a huge spread - from several thousands to several millions. Small investors lament that they have insufficient capital to gain leverage but I have the view that it is harder to manage a larger fund than a small one for many reasons.
My mission is one of helping the smaller investor get a start in the market as I know so many have that as a major goal. But their every move is tempered by a fear – a fear that I understand because I have experienced that myself. Whilst I have taken risks many times in investing I feel the need to do little of that today, as it is not essential to success. Fear can be largely eliminated.
One of the discipline guidelines that I believe is absolutely critical is patience. Accept that accumulating wealth is a long journey – nothing too arduous about that as it can also be a fun journey. If you accept that, then there is no rush and you can then pace yourself. Accepting that pacing yourself is a good thing then that means entering a market in controlled stages and building up momentum gradually has to make sense. This gradual strategy ensures that you gain in experience, that you have a sense of where the market is going and you can best control your risk levels – this is not “caveat emptor” stuff – it is good old common sense!
If say you had $40,000 that you wanted to invest in the stock market – assuming this was not money that you had scraped together and you still had reserve cash for emergencies etc., then how does one spread this capital over various stocks?
My approach would be to spread this capital over 10 parcels of shares and it may take several weeks or months before you were fully invested. Let’s assume you plan that this capital was earmarked for long term capital growth then hopefully you will not want to be switching in and out of stocks and that you will be aiming to follow the long trend up. In my experience to have 10 stocks in a long term portfolio you will need to have churned through maybe 14-18 stocks. That is you will buy stocks that maybe satisfy your entry criteria but do not in time live up to expectations. That is reality. In the worst situation that a stock falls then I generally aim to be out once the stock falls to about 5-10% of purchase price. This strategy means that at times I sometimes make the call a little too early and my impatience results in me watching that stock climb higher after that brief retreat that caused me to exit. Potentially annoying but it also means that I have a strategy that is almost capital guaranteed.
Let’s say in an extreme that the market deteriorates then the most I could lose of my capital of $40,000, is about $4,000 - in theory - but I would argue, also in practice. I can hear the cynics ask what about market crashes? My view is that we get plenty of signals before market crashes – it is how we use those signals is what counts.
The thought of losing even $4,000 hurts but the truth is that investors lose much more than that and when the market does fall they close their eyes, hopeing it will stop soon. And when it falls too far they hide their investment file in denial and forget the whole plan. It is absolutely critical to have an exit strategy that will get you out before any real pain can be endured.
Enough for one article but I hope it provokes some actions that will help you succeed in the markets.
Enjoy the ride.
Tom Scollon
Editor
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