Don't Go Swimming Naked

Keeping with the theme I started last week, today I want to talk to you about something most retail investors completely ignore.

But they’re ignoring it at their own peril, because it’s one of the most important parts of investing.

I’m talking about risk management and the various strategies you can employ to mitigate the threat of disaster striking your portfolio.

There are many risk management strategies that investors can use when investing in the stock market.

And today, we’re going to cover the five most common and also most effective methods: diversification, dollar-cost averaging, hedging, stop-loss orders, and asset allocation.

Before we get started, though, it's important to note that no single strategy can guarantee success or protect against all risks in the stock market.

And even a combination of all five we’ll be covering today won’t protect you from everything.

But it will protect you a whole lot more than the nothing most retail investors use.

So let’s get into the five ways you can best protect your portfolio from almost everything the market can throw at it…

Many Baskets > One Basket

With all the recent talk of the price of eggs, let’s start with the most common risk management strategy: diversification.

It’s literally that old adage of not putting all your (extremely expensive) eggs in one basket.

And in its simplest form, it’s merely a way to spread your money across different types of investments.

If you only invest in one type of stock and that stock doesn't do well, you could lose a lot of money.

But if you diversify and invest in different types of stocks, bonds, and other investments, you reduce the chance that all your investments will do poorly at the same time.

This way, if one of them doesn't do well, the others can help balance it out.

Think of it like this: If you put all your money (or eggs) in one basket and that basket gets dropped, you could lose everything.

But if you put your money (and your eggs) in different baskets, even if one of them gets dropped, you still have some of your money in other baskets that are OK.

For example, a well-diversified portfolio might have a very large percentage dedicated to stocks…

But that allocation is spread out among investments in large-cap stocks, small-cap stocks, and international stocks in varying industries.

In simple terms, diversification helps make your investment portfolio more stable so that you're not too affected by ups and downs in the stock market.

It's a good idea because it can help protect your money and give you a better chance at earning a good return in the long run.

And just for reference, buying several ETFs that all track the same market (like the Dow, S&P 500, and Nasdaq) does not mean you’re diversified.

"BTFD!"

Next up, let’s cover another one you’ve probably already heard about but maybe are wondering what exactly it means.

It’s why many financial influencers will yell at you to “buy the f*cking dip!” And it’s known as dollar-cost averaging…

It’s simply a way of investing a fixed amount of money into the stock market regularly, regardless of the current market conditions.

This means that you invest the same amount of money at regular intervals, like every month.

Think of it like this: If you have a set amount of money you want to invest, you can divide that amount into smaller pieces and invest one piece at a time.

This way, you buy more of the investment when the price is low and less when the price is high.

Over time, this helps to average out the cost of your investment so you don't have to worry as much about timing the market perfectly.

The big benefit of dollar-cost averaging is that it helps reduce the risk of investing in the stock market at the wrong time.

If you invest all your money at once and the market goes down, you could lose a lot of money.

But if you use dollar-cost averaging, you invest regularly, so you're not putting all your money into the market at once.

This helps to spread out the risk so that you're not too affected by any short-term ups and downs in the market.

In the simplest terms, dollar-cost averaging is a way to invest your money into the stock market over time, instead of all at once.

Since you're spreading out the cost of your investment over time and not putting all your money into the market at once, you reduce your risk of paying too much for any one investment.

It's a good idea because it can help make your investment portfolio more stable and reduce the stress of timing the market perfectly.

"We Want a Shrubbery!"

No, as much as I love that scene from Monty Python, that’s not the kind of hedge I’m talking about here.

Hedging in financial terminology is a way to reduce the risk of an investment by taking out a separate investment that's meant to offset any losses from the original one.

Think of it like this: If you're afraid of losing money on an investment, you can buy insurance that will help protect you if things don't go as planned.

For example, let's say you own stock in a company and you're worried that the stock price might go down…

You can hedge your investment by buying options that allow you to sell the stock at a set price no matter what happens to the stock price.

If the stock price does go down, you can sell the stock for the set price instead of selling it for a lower price. This way, you limit your potential losses.

Suppose an investor owns a stock portfolio worth $100,000 and is worried about a potential market downturn.

To hedge against this risk, the investor might buy put options on an exchange-traded fund (ETF) that tracks the stock market.

A put option gives the investor the right, but not the obligation, to sell the underlying ETF at a specific price, known as the strike price.

The benefit of hedging is that it helps reduce the risk of your investment portfolio.

If you only have one investment and it doesn't do well, you could lose a lot of money.

But if you hedge your investments, you reduce the chance that you'll lose money, because you have insurance to help protect you.

And while it sounds somewhat like diversification, it’s actually quite different…

Diversification aims to spread risk across a wide range of investments, while hedging aims to reduce the potential losses from a specific investment by taking an offsetting position.

In simple terms, hedging is like buying insurance for your investments.

It helps reduce the risk of your portfolio so that you're not too affected by any short-term ups and downs in the market.

Plus, it can give you peace of mind knowing that you have a backup plan in case things don't go as planned.

Sell, Sell, Sell!

The market moves quickly, sometimes too quickly for a retail investor to react in time.

That’s why setting stop-loss orders can be such a powerful risk management strategy…

A stop-loss order is simply a type of order that you can place with your broker when you buy or sell a stock.

It tells your broker to automatically sell your stock if the price drops below a certain level.

It works like this: If you buy a stock, you want the price to go up so you can make money.

But if the price starts to go down, you don't want to lose too much money. A stop-loss order helps you avoid big losses by automatically selling your stock if the price drops below a certain level.

For example, let's say you buy a stock for $100 and you place a stop-loss order at $90.

If the price of the stock drops to $90, your broker will automatically sell the stock for you so you only lose $10 and not any more.

The best level for a stop-loss order depends on several factors.

Here are a few of those factors to consider when setting a stop-loss order:

1. Risk tolerance: Your risk tolerance is a crucial factor in determining the best level for a stop-loss order. Investors with a lower risk tolerance may want to set a stop-loss order closer to their purchase price, while those with a higher risk tolerance may be willing to set a stop-loss order further away.
   
   
2. Investment goals: Your investment goals can also play a role in determining the best level for a stop-loss order. For example, an investor who is looking to hold onto a security for the long term may be willing to set a stop-loss order further away, while an investor who is looking to quickly lock in gains may want to set a stop-loss order closer to the purchase price.
   
   
3. Technical analysis: Some investors use technical analysis to determine the best level for a stop-loss order. For example, an investor might set a stop-loss order below a key support level or above a key resistance level.

The benefit of stop-loss orders is that they help you manage your risk when investing in the stock market.

If you don't use a stop-loss order, you could end up holding onto a stock for too long and losing a lot of money. But if you use a stop-loss order, you can limit your losses and protect your investment.

In the simplest of terms, a stop-loss order is a way to automatically sell a stock if the price drops below a certain level.

And it's a good idea because it helps you manage your risk and limit your potential losses when investing in the stock market.

By using stop-loss orders, you can take emotions out of the equation and ensure that you're making smart, rational decisions about your investments.

Diversify Your Diversification

So far, we’ve covered the need to spread your investments out across multiple industries, but we haven’t covered spreading them out over multiple asset classes.

And that’s exactly what asset allocation is all about.

It’s similar to diversification in that it aims to reduce risk in an investment portfolio. But it goes about it in a different way…

Diversification refers to the process of investing in a variety of different securities within a single asset class with the goal of reducing risk by spreading your investment across a wide range of individual securities.

Asset allocation is the process of dividing your investment portfolio into different types of investments, such as stocks, bonds, real estate, and cash.

The idea being to spread your money out into different types of investments so that you're not relying on just one type of investment to perform well.

For example, you might allocate 60% of your portfolio to stocks, 30% to bonds, and 10% to cash.

This way, if stocks aren't performing well, you have bonds and cash to help balance out your portfolio and protect your investment.

The benefit of asset allocation is that it helps you manage your risk when investing in the stock market. If you only have one type of investment, you're taking on a lot of risk. But if you spread your money out into different types of investments, you can reduce your risk and protect your investment.

In simple terms, asset allocation is a way to spread your investment portfolio out into different types of investments, like stocks, bonds, and cash.

It's a good idea because it helps you manage your risk and protect your investment so that you're not relying on just one type of investment to perform well.

By using proper asset allocation, you can make sure that your investment portfolio is balanced and well-diversified, which can help you achieve your financial goals.

Bottom Line

The bottom line here is that risk management is a very important part of investing. But it often gets ignored by retail investors.

It will help you control the potential losses from your investments and achieve your financial goals more quickly.

Risk management is especially important for retail investors like us because we usually don’t have all the resources or expertise that institutional investors do.

That makes us more susceptible to market volatility and potential losses.

But by using risk management techniques, retail investors like us can better protect our hard-earned money and feel more confident about our investment decisions.

And by taking steps to manage risk, we can help ensure that our investments are protected and that we are on track to achieve our financial goals.

It’s like having a safety net for your investments. And who doesn’t like feeling safer?

To your wealth,

Jason Williams

@TheReal_JayDubs

Angel Research on Youtube

After graduating Cum Laude in finance and economics, Jason designed and analyzed complex projects for the U.S. Army. He made the jump to the private sector as an investment banking analyst at Morgan Stanley, where he eventually led his own team responsible for billions of dollars in daily trading. Jason left Wall Street to found his own investment office and now shares the strategies he used and the network he built with you. Jason is the founder of Main Street Ventures, a pre-IPO investment newsletter; the founder of Future Giants, a nano cap investing service; and authors The Wealth Advisory income stock newsletter. He is also the managing editor of Wealth Daily. To learn more about Jason, click here.

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