6 Simple Steps to Reduce Risk

07/13/2011 7:30 am EST

Focus: MARKETS

Timothy Lutts

Publisher, Cabot Heritage Corporation

These types of markets are the best time to take hold of your fears and do something to mitigate the risk in your portfolio…and it’s not that hard, notes Timothy Lutts of Cabot Wealth Advisory.

I attended an unusual wedding Saturday.

There was no church, no procession, no giving away of the bride, no maids of honor, no flower girls, and no groomsmen. There was none of the traditional pomp and circumstance that so many brides and their mothers obsess over.

There was a clergyman of some sort (he had a white collar). There was a ring. There were vows, and there was a poem, written by the bride’s father, who is a professional poet and teacher.

And there was food and drink and dancing, with music coming from a laptop computer paired with a powerful sound system. In fact, the music and the drinking started before the wedding ceremony!

But what I’ll always remember is the fact that the wedding, which was held on a large dock in the fishing port of Gloucester, Massachusetts, was delayed just a bit. And the reason for the delay was that a body had been found floating in the water!

That fact was not broadcast to all the guests, but the bride was aware of it, and it didn’t seem to bother her a bit; she’s a strong, intelligent young woman. But the news did leak out, and I thought it added a whole new layer of intrigue to the festivities, because at the time, the identity of the dead man, as well as the circumstances that led to his death, were unknown.

Today I know. He was a 48-year-old sailor who had stopped in Gloucester on his way back from Bermuda to his home in Yarmouth, Maine. After mooring his 44-foot sailboat at a local boatyard, he apparently had a mishap while transferring to shore in his inflatable boat.

This incident, coincidentally, is remarkably similar to one that I originally planned to open this column with.

Last week, a 22-year-old man from St. Paul, Minnesota drowned in a Wisconsin lake, after a small boat carrying him and five friends capsized and he tried to swim to shore.

The same night, an 18-year-old man from Peabody, Massachusetts, who was planning to go to college in the fall, lost control of his 2002 Chevy Trailblazer on the highway, crashed, and died.

A few days before, a 55-year-old man from Parish, New York, lost control of his 1983 Harley Davidson motorcycle, flew over the handlebars, landed on his head and died. Ironically, he was participating in the annual Helmet Protest Run staged by the Onondaga County chapter of American Bikers Aimed Towards Education (ABATE).

What these deaths have in common is simple. They all could have been avoided if the men had done one of three simple things: worn a seat belt, worn a life preserver, or worn a helmet.

But they didn’t, and they won’t get a second chance.

Which applies to investing how? Well, from one perspective, it’s all about controlling risk.

The men above had no doubt been told more than once in their lives that they should wear seat belts, life preservers, and helmets. But in these instances, they chose not to. The older man riding to protest helmet laws made a very conscious choice in not wearing the helmet; for the other two, the choice was probably less conscious.

But the result for all three was an increased level of risk, a level that proved fatal.

In the investing business, happily, even high risks are seldom fatal. But they can certainly hurt, and the sooner you learn to identify and eliminate the greatest risk factors in your own investing, the sooner you’ll be on the path to increased profits and decreased pain.

NEXT: My Six Favorite Ways to Reduce Risk

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Here are my six favorite ways to reduce risk:

  1. Use market timing. When the market is in a confirmed downtrend, you should be in a defensive posture, keeping a lot of cash on the sideline, or even selling short.
  2. Never buy a growth stock without consulting the chart. And then don’t buy it unless the chart promises that potential reward outweighs potential risk. That means looking for historically productive patterns like sturdy bases, high-volume breakouts, and normal pullbacks.
  3. Don’t invest heavily in your own employer. That concentrates risk. Just ask the former employees at the now-defunct Enron, many of who plowed all of their retirement savings into Enron stock and were left holding an empty bag. Instead, you want to spread risk by diversifying, even if it means investing in your employer’s competitors!
  4. Don’t fall in love with any individual stock. It will cloud your judgment. And if you’re already in love with a company, don’t invest in it. You need a clear head to be a successful investor.
  5. Cut losses short when a stock disappoints. Never let a loss grow larger than 20%; in most cases, the chart will tell you to sell it before your loss grows that large, particularly if you’ve consulted the chart before buying (see No. 2). And if your records show you have trouble cutting losses, use mental stops—a crude, but often effective tool.
  6. Finally, when a stock you own becomes a big winner, take a little profit off the table from time to time, especially after major advances when the news is really good. You don’t want to become over-weighted in one stock; it increases risk.

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