Secret #2: Go With "Low Risk"–And Then Let Your Winners Run You've learned that
first secret shared by 99% of world's greatest investors is that they never–ever–allow any one of their investments to rack-up huge losses in market. We've seen how trailing stops help there.
The other secret is that they always invest in what they call "low-risk" opportunities. Now, as you'll see, that doesn't mean their stocks or investments carry no risk or that they're not expecting very high gains from these investments. Quite contrary.
After all, we can't make 30%, 50%, or 70% each year if we have our money in savings accounts or money market funds. Those are low-risk strategies for your money, but they're also extremely low profit. For world's most successful investors, low risk means entering only into positions where probability for high profits far exceeds possibility of losses over long run. They invest their money in such a way as to position themselves for maximum profits while–at very same time–ensuring that their exposure to serious loss is absolutely non-existent.
A High-Profit Tool for Sophisticated Investors
"Position sizing" is really all about money management. But it's not kind you use to make sure you have enough money on hand to pay expenses like mortgage, household bills, college tuition for your children, car payments, etc.
The money management connected with position sizing is strictly limited to your investment portfolio. And it's every bit as crucial to your profits as trailing stops and stocks you choose.
That's because this management process tells you how much you should invest in your positions so that you're not risking more than you're comfortable with. Position sizing also helps you when you decide it's time to add to your winning investments–a process we'll discuss in a moment.
The Marble Game
At many seminars he speaks at each year, Dr. Tharp illustrates importance of position sizing by having participants play an investment game using a bag of marbles...
At start of marble game, participants are each given $100,000 in play money to seed their portfolio. There are 20 marbles in bag, each one representing either a losing (black marble) or a winning (white marble) trade. There's one more interesting variable. Sixty percent of marbles in bag are winners while 40% are losers. And each marble is replaced after it is drawn.
One of winners is a "10 times winner," and one of losers is a "5 times loser."
Now, odds of winning in this marble game are far higher than odds you and I face in markets. Still, when Dr. Tharp conducts this game with his seminar audiences, more than two- thirds of participants always lose money. And a full one-third go bankrupt!
How can a majority of people lose in a game in which odds are so heavily in their favor?
The answer is very simple: Those who lose money do so because they have no idea how much they should be investing in any one marble draw. They are playing game without a "system," so they're really doing nothing but gambling. This sort of approach doesn't win marble game. And, in real-world investment game, it won't lead to long-term wealth.
The key to success they're missing in marble game– and strategy you should use in your portfolio–is position sizing.
Successful Investing Is Emotionless Investing
Just as we saw when we were looking at trailing stops, investors in this marble game lose money because they get caught up in emotions of investing. During his marble game, Dr. Tharp does just what's needed to push all "hot buttons" of his audience...
For example, after 10 pulls from bag, he'll ask to see hands of all those whose play-money portfolios have doubled in value. And a few hands always go up. Of course, when others in game–the vast majority–see that a few of their fellow participants have hit it big already, worry and envy enter picture. And what do you think happens?
In an attempt to catch up with winners, other participants start increasing their bets. Problem is, when these ill-considered bets turn out to be losers, they're doomed to failure–they dig themselves into a hole they can't get out of.
Now, I'll show you how you could win in this marble game. It's same way you'll win in real-life investing game– game that will determine level of wealth you're going to attain in this life. Here's how you can pursue very same low- risk ideas world's best investors go after...
First of all, I'm assuming that you'll be following our investment advice and always have 25% trailing stops on your investments. The 25% is our rule–you can chose your own percentage. The most important thing is that you use it consistently!
Based on this assumption, for your investments to be low-risk, you should be dealing with odds of at least 2-to-1 or 3- to-1 in your favor, and that means you should be expecting returns of between 50% and 75% on your profitable investments.
We arrive at those figures knowing that because you'll never lose more than 25% on any one investment (you'll be stopped out at a 25% loss), 50% and 75% gains represent, respectively, 2- to-1 and 3-to-1 odds.
To give you another example, let's say you invest in a stock that you expect to return only 30% rather than 50% or 75%. To keep your investment low risk (and your odds at 3-to-1), you'd have to change your trailing stop from 25% to 10%.
Whatever your expected profits, here are two "golden rules" you should follow:
Know your worst-case scenario to keep from going bankrupt Determine how much you're willing to lose in any one investment
Now we'll see how you would apply these two golden rules to Dr. Tharp's marble game in order to come out a winner.
You'd first have to decide how much of your $100,000 you were willing to lose on any one marble pull. Now, because you're adhering to The Oxford Club's 25% trailing stop rule, that decision won't be difficult for you–you know that 25% is maximum you're ever going to lose. So you would never want to put more than 5% of your money on any one marble–because if you were to pull that 5 times loser out of bag, you'd hit your stop-loss limit (5% x 5% = 25%).
You'd have to start with a bet of $5,000 (5% of $100,000). But what would you do next? Would you simply continue to bet $5,000 on every marble you pulled from bag? Well, because odds of this game are heavily stacked in your favor, that strategy would probably mean you'd end game with more money than when you started.
So it would be a good strategy–but it's not best you can do...
To really optimize profit on your investments–in marble game or in real life–you should scale size of your investments to amount of total capital you have in your portfolio.
Always Know Exactly How Much to Invest for Maximum Profit and Comfort
