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One way to ensure you don't take on too much risk as an investor

by , 22 August 2014

Many investors spend their investment career battling against the market. This leaves them taking on too much risk and not reaping the rewards.

You buy into a share. The share price plummets, but you hold on and in the process lose money.

Or you buy into a share. The share price rockets, but you sell out quickly to grab profits when there's still a lot more to come.

So how can you ensure you don't lose your fight with the market and lose money along the way?

Read on to find out…

Aim to make three times what you risk

You shouldn’t invest unless you expect to make three times the amount you’re risking.

For example, a share is trading at R400. You implement a 25% trailing stop. So in this case, you set your trailing stop at R100 below your buy in price.

Before buying the share, you need to have reasons to believe the share price will rise R300 for you to go ahead.

There can be a whole host of reasons why you believe a price target of R700 is achievable, Marc Lichtenfeld in Investment U explains. Your charts may show you a specific pattern that looks like the share price will rise R300. Or maybe a R700 target makes sense from a valuation perspective.

But if your charts are telling you that the share price isn’t going to rise above R600, you shouldn’t buy the share.

Why aiming for lower potential returns increases your risk

You might think that making 50% is worth the risk. But by adhering to a 25% trailing stop, you want to know that a 75% gain is achievable. This way, you can be wrong two out of three time and still make a profit.

If you buy a share where you expect your profits to be 50%, then you have to be right half of the time. So by buying shares where you have to be right only a third of the time, it reduces your risk and gives you more comfort as an investor.

The three times your risk rule makes you a more disciplined investor. And discipline is great as an investor. Yes, you may miss out on some stocks, but this strategy also ensures you don’t buy shares that don’t look likely to reward you.

Of course, even if a prospective investment adheres to your three times risk rule at the start, you don’t have to stick with it. Things change and if the charts start to tell you something different a few months in, you can change your mind.

By sticking to a solid rule when you invest in a share means that you’re more likely to pick better opportunities to start with.

So there you have it, one way to ensure you don’t take on too much risk as an investor.

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One way to ensure you don't take on too much risk as an investor
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