“The key to long term survival and prosperity has a lot to do with the money management techniques incorporated into the technical system. There are old traders and there are bold traders, but there are very few old, bold traders.” – Ed Seykota (The Market Wizards)
The purpose of this essay today is to show you two more ways to reduce your investment risks while you make bigger profits.
Most people, when they are investing, simply follow their own natural inclinations, and, in doing so, they feel that they are avoiding risk. These natural inclinations often lead them to heavy losses.
You learned about the most important factor in reducing risk — stop-loss orders — in Message #573. Today, we’ll look at two more techniques for reducing the risk of any investment.
Technique No. 1: Diversify over time.
One of the best ways to reduce your risk is to diversify over time. This means that you must always keep enough money in reserve for those special trades that occasionally come along or even for routine trades during entirely different market conditions. This is also called reducing your “exposure” to risk.
Think about it this way: If you win 90% of the time but risk much of what you have every time you trade, you will eventually lose everything. This is one of the common mistakes of small and novice traders.
Technique No. 2: Diversify your account.
If you open several simultaneous positions, trade only independent, low-risk ideas. If your positions are independent, three different positions might be enough to diversify adequately. When one position goes down, another independent position might go up, thereby providing you with some protection.
Most people don’t understand diversification. The stocks of two international oil companies, for example, are not independent, because their prices will tend to move together.
Similarly, gold and silver contracts would not be independent, since both are precious metals and they too tend to move together. Adequate diversification might involve stocks, commodities, and financial instruments, since all of these can be relatively independent. For example, a soybean contract, a Euro contract, and the stock of a steel company would be good examples of fairly independent trades.
In my courses, we cover more than a dozen easy ways to not only reduce your chances of losing money but also to maximize your profits. I’ll introduce you to some of the more sophisticated techniques in future ETR essays.