Golden Rule #2
Controlling risk is just as important as maximizing gains.
We all have a natural tendency to focus on the spice and excitement of investing the performance. There's nothing wrong with that the profit potential can indeed be a very important driver of your ultimate success. However, the steps below to avoid and control risk are equally vital.
Step 1. Objectively evaluate your personal tolerance for risk. Remember: An investment that may be suitable for someone else could be inappropriate for you, depending on how much risk you are comfortable taking, the number of years you have before retirement, your income level and tax rate, your other existing investments and personal net worth, plus your expectations about investment performance. So to help you evaluate each of these issues and come up with a total "risk score," be sure to run through our Risk Self-Test. It will only take a few minutes. But it could make a real difference in your results and your peace of mind.
Step 2. Determine portfolio allocations that are right for you. Included with the Risk Self-Test, you'll also find guidelines on how to use your results to help you decide how much of your money to allocate to savings or capital preservation how much to allocate to growth, and how much you could spare for speculation.
Step 3. Find out the risk level of each investment. We provide a rating on virtually any mutual fund or listed stock right here at www.safemoneyreport.com. Just log in and click on the "Ratings" menu.
Step 4. Control your risk. High-risk investments are not bad. Indeed, often they are the outstanding performers. So, there certainly is a place for risk, provided you take advantage of the devices that can help you control that risk. Specifically:
* For investments that expose you to large potential losses, use stop-loss orders. In the Safe Money Report, we usually recommend a stop loss on investments that we feel may expose you to risk. If the value of your security falls, there is no guarantee that you will get a price that corresponds exactly to the stop-loss level we specify. But it should help protect your capital to a large extent either to prevent a larger loss or to protect an open profit.
* Diversify beyond the stock market by investing in various asset classes. Some people think that "diversification" means spreading your money among multiple stocks or stock market sectors. We have never believed that to be adequate, and the wholesale decline of nearly all market sectors in 2000-2002 vindicated our views. A truly diversified portfolio should also include Treasuries, gold-related investments, other hedges against inflation or deflation, and, at the right time, other asset classes like real estate.
* Maintain a balanced portfolio. Too many investment decisions are based on just one theory about the future direction of the market. At Safe Money, we do have strong views about the future, but we also recognize that, ultimately, the future is not predictable with any level of precision. Therefore, one of our key goals is to build a portfolio that should be able to handle multiple future outcomes. For example, Treasury notes and bonds (at the right time) are generally well suited for a deflationary environment. You lock in a high yield and you can enjoy capital gains from rising prices. However, your portfolio should also contain some allocation to investments that can serve as inflation hedges.
Warning: These and other risk-control devices are never foolproof. But if you use them consistently and wisely, they are bound to improve your overall performance in the long term.
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