5 Steps to Eliminate Investment Risk

Like many of you, I am an investor and a trader. If you are also in the markets today, you are surely finding it to be increasingly difficult to locate safe places to stash your cash.

In the past year we have seen silver go from $16/oz to $36/oz. We have seen gold go from $1084/oz up to $1431/oz.

The S&P 500 is up about 30% off of its lows of last summer and trading at around 24x earnings. Corporate America balance sheets are still holding record amounts of cash.

The Fed is about halfway through with the $900B QE2, and most likely will follow that up with QE3, 4, 5….16.

Ironically, Bill Gross, co-CIO of Pimco, was in the news today discussing how he has dumped ALL of his US government debt holdings in the PIMCO Total Return Fund.

Let’s recap:

• Gold at all time highs
• Silver at all time highs
• Stocks expensive
• Soon to have runaway inflation
• The biggest bond investor in the world no longer wants US debt

In addition to the difficulty in finding a decent place to store cash, we are seeing a surge in litigation putting your hard earned wealth at risk.

Today I will share with you the basics of structuring a portfolio that allows for growth while nearly eliminating your downside risk. I will also give you a basic asset protection plan on how to shield your investment assets from the many parasites that want to feed off of your productivity.

Step 1 – Diversification and asset allocation.

Many people know this, but very few actually put this into practice. I am going to specifically talk about individual stocks because for me, this is much easier and safer to manage than a basket of mutual
funds. In essence, you are creating your own mutual fund.

Hold 20-25 stocks (I won’t go into stock selection because this is beyond the scope of this article) and never allow any one holding to constitute more than 5% of your investment capital.

Spread your stock holdings out into several different industries. Don’t just buy 10 retailers and 10 tech companies.

Keep 10-20% (sometimes more, depending on market conditions) of your investment capital in cash or cash equivalent. This allows you to take advantage of opportunities when they arise. As the saying goes, “keep your powder dry.”

Step 2 – Stops.

Keep trailing stop loss orders on all of your equity positions. For those of you that don’t know, a trailing stop is a stop loss order that ‘trails’ up as your stock price increases.

For example, if you buy XYZ at $20/share with a 25% trailing stop, then your initial stop loss order is set at $15. If XYZ moves up to $30/share, then your stop loss order moves up to $22.50. This allows you to limit your downside risk while allowing your stock to run up continuously.

I usually start all equity positions with a 25% trailing stop. If my account value is $100,000 and I have followed my asset allocation rules, then my maximum investment in any one stock is $5000. With a 25% trailing stop, I would sell this stock if it fell to $3750, realizing a $1250 loss. This limits my portfolio loss to 1.25% per position.

As my equity positions run up in price, I usually lower my trailing stops to 10-15% depending on the volatility of the stock. This allows me to lock in profits while still giving the stock room to run.

When I use trailing stops, I am allowing the winners to run and cutting the losers early. By combining my asset allocation rule with my trailing stop rule, I have severely limited my downside risk. Most inexperienced investors are only concerned with making money. I focus on limiting risk.

This is truly one of the greatest hidden secrets of intelligent investing. Most people want to sell their stocks when they see a hint of profit, but ride the losers to the grave to protect their ego from a loss. “It will come back up” should be eliminated from your vocabulary. It’s an emotional reaction and has nothing to do with making money.

I spent time recently in Chicago with a friend of mine who is a very successful trader at the CME. He said, “Money is money. I can make up my losses anywhere; it doesn’t have to be in the same investment where I lost the money.” The market is without emotion, follow its lead.

Step 3 – Reinvest dividends.

The vast majority of my equity positions are dividend payers. Historically dividend payers generate superior returns with less volatility than companies that do not pay dividends. Nearly every company out there that pays dividends has a dividend reinvestment plan (DRIP). Take advantage of it.

Whenever the company issues a dividend, if you are enrolled in its DRIP, you don’t get the cash. Instead, you get shares of the company stock. These companies will issue partial shares as well.

This is truly the power of compounding at work.

If you buy 100 shares of a stock at $20/share that pays a $.50 quarterly dividend, you will receive a $50 dividend in the first quarter. Your initial equity value is $2000. After the first dividend is paid, you will receive an additional 2.5 shares of stock (for simplicity sake, we assume the share price is flat).

At the beginning of the 2nd quarter, you now have 102.5 shares. When the next dividend is paid, you will receive $51.25, or 2.56/shares of stock. While this may not seem like much, after a few years, you can easily earn huge amounts of dividends from your initial
investment.

In the example above, if you buy 100 shares of XYZ at $20/share, you have invested $2000. Assuming the share price remains constant and the dividend stays at $.50/share, without reinvesting dividends after 10 years you still have $2000 in stock and $2000 in dividends, or $4000.

If you had reinvested those dividends through the company’s DRIP, you would have $5239.15. That’s a 31% difference! This is the power of compounding interest.

Step 4 – Insurance.

This is the step that provides the most confusion to the majority of retail investors. I am talking about put options. If you allocate 1% of your portfolio each year to buying put options, you have virtually eliminated all of your market risk for only a fraction of your investment capital.

Put options are insurance. It’s really no different than buying car insurance. You pay a premium to minimize your risk just as you would when you buy an auto insurance policy.

For example, if your account value is $100,000, you could buy $500 of SPY put options every six months. Today, you would probably buy options with expiration in September. As the market fluctuates, these put options will go up or down according to the movement of the S&P500 index reducing volatility in your account.

Martin Zweig wrote a book about 15 years ago called “Winning on Wall Street”. In this book he discusses how this technique actually made him money during the stock market crash of 1987.

On that day, his portfolio surged by 9%. Martin used trailing stops religiously and was stopped out of 90% of his equity positions as the market tumbled. Because he had allocated 1% of his portfolio to index put options, the value of these options skyrocketed as the market tanked giving him a nice profit for the day while the rest of Wall Street was looking for a high rise to jump from.

Step 5 – Create a veil of privacy.

In the February 10th, 2011 issue I discussed asset protection for the stock market investor. I won’t go into detail here (if you didn’t get it and want a copy, email me the request referencing the date), but will hit the highlights.

I recommend never, ever, ever owning your stock portfolio in your name personally. This makes it too easy for financial predators to find your assets. If you are ever sued, liquid assets are the easiest to attach.

At a minimum, you should have a properly structured LLC as the stock portfolio owner. As a side note here, nearly every LLC I have ever reviewed were done incorrectly. Not all LLC’s are created equal. Don’t put your financial future at risk here, do it right.

For those of you more inclined to create the ultimate asset protection plan, you could have your portfolio owned by an offshore LLC; which is then owned by an offshore trust. The LLC would be the account owner and could have multiple trading or bank accounts in various jurisdictions to further diversify geographically.

By using this, or a similar structure, you are abiding by JD Rockefeller’s 1st commandment, “Own nothing, but control everything.”

These are the same type of strategies that have been implemented in our private investment partnership over the years. This has given peace of mind by minimizing risks from market fluctuations as well as risk from parasitic predators.

I encourage you to take some of the same steps. I would love to hear from readers who are experienced investors about their techniques for minimizing risk and maximizing their own portfolios.

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