As I have talked about in my previous article, The Holy Grail of Trading, risk management is one of the most important factors when it comes to trading. Many investors are not aware with how much risk they are taking on. Others are so blinded by high returns that they chase very speculative investments and it cost them thousands of dollars. In this article, I’m going to be breaking down what risk means in the markets and a great way use it to your advantage to get you an extra $5,000 dollars this year.
What is risk?
We take on risk every day in our lives. A great example to describe how we make decisions on risk is a person walking to a grocery store in New York City. One route he could walk will be completely safe and he will get to the grocery store in approximately 30 minutes. Another route is known to have lots of crime and there is a good chance he will get mugged BUT this route would only take him 15 minutes to walk. As you can see there is higher risk (getting mugged) for a higher reward (getting to the grocery store 15 minutes faster).
This same concept can be applied to us as investors. There are riskier investments out there but people are attracted to them because they provide higher chance for reward (More $$$$). Here’s a list of what I consider to be high risk investments:
- Penny stocks
- New & Growing Companies
- Basic Options
You may not know what all of these are but the major takeaway is that all of these products revolve around speculation and a great risk to your principal (you could lose a big portion/all of your investment).
Let’s take a look at New &G rowing Companies for example. People believe that blue chip stocks are safer investments because these are companies that have been around for many years and have performed well over time. This is your GM, Johnson and Johnson, IBM, Proctor and Gamble, and so on. New & Growing companies are more speculative investments because they have no track record built up yet. If you were to invest in them you COULD see a great return because the company could take off! But you just as well could see the company sink and turn into another failed startup.
Risk in Our Portfolio
When we think of risk in our portfolio we are concerned with how much of our money we have in one particular stock or fund. Recall in previous articles, I’ve mentioned that as you grow your portfolio you want to diversify across different asset classes to spread out risk. This is done so that if one asset class takes a hit, your entire portfolio will not lose lots of value.
THE PERFECT STRATEGTY
A strategy that I highly recommend to take on risk is called the core and explore approach. This is simply having 80% of your portfolio as your long-term growth strategy and 20% for your higher risk/reward investments. For the example of core and explore assume you are an investor with a portfolio of $150,000. Let’s dive in deeper:
The core of your portfolio is your mix of different asset classes across different sectors that’s going to produce most of returns year-after-year. This is your nest egg and the foundation of your retirement. As you get closer to retirement you want this to get more and more conservative to protect your principal. Here’s a breakdown of what could be part of the core of your portfolio:
- Mix of stocks across different sectors
- Etfs/Mutual funds
- Real Estate
The explore section is the fun part of your portfolio. This section allows you to take 20% of your assets and put them into riskier investments to try and get a better return. Losses taken with this portion of your portfolio will not greatly affect your yearly returns. The goal is that they will produce greater returns than you could have imagined because they have higher chance for reward. In this scenario with $150,000 dollar portfolio, I am assuming that your explore portion will make you roughly a 10% return on your investment ($5,000). Here’s a breakdown of what could be part of your explore section of your portfolio:
- One stock you think has high potential for breakout
- Biotech’s about to announce a new drug for approval
- Day Trading
Think of this strategy like your diet. 80% of what you eat is your core nutrition and are foods that you KNOW are good for you. 20% is new foods/restaurants you haven’t tried before but could really end up liking. (sweets included J)
Homework: Think about your portfolio and how long you have before retirement. Depending on your age and how much you have saved up, think about a way to start incorporating the core and explore approach. I guarantee this will help you stay on track with your investment goals while allowing you some flexibility taking on risk.