a stock because of a short-term price drop will stop your losses in the short term, but if the stock reverses itself and goes back up and beyond the price at which you sold it, the decision to sell will cost you the profit you would have made if you’d simply hung on to the stock.
• Diversifying will cost you money compared to what you would have made if only you’d known which single stock in the universe was going to do the best and just bought that.
So why practice risk management? To protect against devastating losses. In the long run, your returns are most likely to beat the market if you avoid outsize losses. The idea is to balance risk vs. reward opportunities in order to produce the greatest return overall.
Risk techniques range from the extremely simple—like easing your way slowly into the market—to highly complex activities utilizing sophisticated investment products and strategies that are beyond the ken of the average individual investor. In this regard, one often hears the term ''hedging.'' Hedging is a subset of risk management. The term usually means buying (or selling) something—like another security, an option, or your own stock short—which theoretically offsets the risk of what you already own. But the Sensible Stock Investor can manage risk using simpler techniques.
Why is controlling losses so important? Because it is so hard to make up for them. Let’s look at a few examples. If you lose just 5% in a stock, it only takes about a 5% gain to make up for it. But as the percentage of loss grows, the percentage you must gain back—just to get back to even—grows geometrically. A 25% loss takes a 33% gain to get back to even. A 50% loss takes a 100% gain. Some of the dot-com high-flyers of the late 1990’s lost 90% of their market value. What do you think it will take to get back to even? A 900% gain! Realistically, that’s not going to happen.
So the Sensible Stock Investor avoids outsize losses in the first place. Remember Buffett’s Rule #2: Don’t forget Rule #1. And what was Rule #1? Don’t lose.
Article Source: http://www.ArticleJoe.com
If you would like to learn about a comprehensive stock investment approach that that uses the same strategies reflected in this article, please consider purchasing ''Sensible Stock Investing: How to Pick, Value, and Manage Stocks.'' This new book describes in detail the relatively simple techniques that the individual investor can use to sidestep large losses—such as not using margin, not selling short, and controlling losses with sensible sell-stops. For more information, book excerpts, an author biography, etc., visit www.SensibleStocks.com
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