Why Risk Management Can Boost Your Profits

First off, today I’d like to discuss choosing your investment horizon. Risk and return are really important, but the most important question you ask might actually be this: How long am I investing for?

Your time horizon will determine your style in a big way. Day traders have very short horizons — they don’t use fundamental analysis (nor do they need to). Many individual investors, whether or not they admit it, get caught up in the next quarter’s earning surprise and are therefore investing for about three months.

Investing for the next quarterly surprise is a playable game, but you should understand you are competing against people who do it full-time. You might be smarter, but you are trying to beat professionals who spend their whole week on a handful of stocks.

They may move the market; they may know the people who move the market (just to clarify that institutions, not individuals, move the market). We are not saying short-term horizons are bad for your investments, but individual investors should realize they will be playing a tough game.

This is why it may be wise to set a longer timeframe, find good companies, let the hedge funds obsess on quarterly fluctuations and wait for the market to recognize your good companies. The good news is sometimes it happens sooner that you think!

My second tip to Profit Confidential readers is to construct a defensive portfolio. Far too often, investors do not practice the simplest risk-mitigation tactic of avoiding big mistakes. Somewhat instinctively, investors seem to hunt for big game — because defending against losses is, well, boring. But, if you can manage to avoid losses, you really might do wonders for your average profit.

David Swenson was the famed investment manager for Yale’s endowment fund — he achieved an annualized return greater than 16% for over a decade, consistently outperforming his peers. Many have marveled at his brilliance, but comments made by one of his board members, Charles Ellis, have shed some light on the reason for Swenson’s success. According to Ellis, Swenson managed to construct one of the most defensive portfolios he had ever seen. In other words, Swenson’s portfolio was designed to avoid losses.

What could this mean for you? You should balance your search for high-return stocks with a vigorous effort to identify red flags. Familiarize yourself with the downside. This is harder to do, because it is not as much fun as looking for growth.

After you’ve found a company you think can be a great investment, resist the temptation to plunge ahead and instead start to look for the company’s potential landmines. Develop a checklist of possible red flags, and work down this list before every investment.

If the red flags start to pile up, you have to find the discipline to let the “fish” go, at least for the moment. One of the hardest things in investing is to find a company, become infatuated with it, get all geared up to buy the stock, and then, upon discovering a big red flag, find that you have to take a pass.