The Most Important Investment Principle of All
by Porter Stansberry
October 6, 2006
What I’m going to show you in today’s essay is, I believe, the most important investment principle you’ll ever learn.
If you follow it, as I do with my own money, you will never again have to worry about losing lots of money on any single investment. You will always know when to sell. And you will know how much money you should be investing in the first place.
For many years, I have maintained that 90% of the profits I make come from these “money managing” strategies. Most people think that because I’m a stock picker, my market-beating results stem from fundamental research and the advantage this knowledge gives me.
It’s true: Knowing a lot about a group of stocks helps you find the right ones to invest in, but this will only contribute about 10% of your gains over time. Most of the gains in stocks come from capturing swings in market sentiment.
I’ve found these swings to be, in large measure, impossible to predict. Instead, by using a simple, but reliable, strategy that I outline below, I have found I’m able to profit from the market’s upswings while strictly limiting my downside exposure.
This strategy is actually a two-step process of investing that I follow with every stock, bond, or currency.
Step #1: Letting your winners run and cutting your losses short
The first and most important principle of speculation is to let your winners run and cut your losses short. And even though the principle is well known, almost no one actually uses it. It’s just too hard emotionally.
When you’ve got profits on the table, every urge tells you “take ’em.” When you’ve got big, ugly losses staring back at you from your account ledger, every emotion says, “hold on – they aren’t losses until you take them.”
Don’t do it. Instead, cut your losers early and often. Remember that you have to have capital to make more money. Nothing sets you back like a large loss. Take many small losses and no big ones and you’ll die a rich man. You can read exactly how to cut your losses with “trailing stops” here.
Step #2: How much to invest in any single investment
The second principle that applies to every investment has to do with diversified money management.
It doesn’t matter what you’re trading, or investing in. You shouldn’t put too many eggs in any one basket.
As a rule, I never put more than 5% of my total portfolio in any single investment idea.
The whole purpose of using a trailing stop is to prevent what I call a catastrophic loss. A catastrophic loss occurs when any single position in your investment portfolio experiences losses large enough to wipe out your other gains and/or jeopardize your livelihood.
One of the biggest differences between professional investors and amateur investors is the size of their positions relative to their total portfolio. Professionals consider a 2%-3% position enormous. Having 5% of your money in any one position is considered “gun slinging” by most professionals.
Meanwhile, at conferences, when I tell investors they should never allocate more than 4% of their portfolio to any stock initially, people look at me as if I’m nuts.
In fact, I would bet that 99 out of 100 individual investors wouldn’t even know how much money they can afford to invest in a given stock, limiting the position to only 4% of their portfolio. Instead, almost all individual investors measure their position sizes in terms of shares, typically round numbers, i.e. “I own 50 shares.”
Think like a pro – think about your positions as a percentage of your portfolio, not as a number of shares. Know the stop loss points of all your positions, at all times.
This doesn’t mean you have to check the stock tables every day.
Follow this two-step principle – by cutting your losing positions, and by minimizing your positions to no more than 4% of your overall portfolio - and I promise you, you’ll see better investment results, immediately.
Good investing,
Porter Stansberry
Editor's note: Porter Stansberry is a regular contributor to DailyWealth, a free investment newsletter focused on the world's best contrarian opportunities. We write with a simple belief in mind: You don't have to take big risks to make big money with your investments.
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