I talk a lot about managing risk, and for good reason. I recently saw a social media post illustrating the problem of taking excess risk.

People who don’t understand basic math tend to do risky things. If you think you can make up big losses because a stock has historically had excellent returns, you need to understand how this works.

The original comment and the response are both badly wrong. Can you see the problem? I like to illustrate problems using simple examples.

Let’s say an investor started out with $10. A 100% return on $10 is $10, giving him a total of $20. A 1,000% return on $10 is $100, giving him a total of $110. So, let’s see what it takes to get to $110 if he first takes a loss of 50%.

A 50% loss means that his $10 is now $5. So, now he needs to go from $5 to a total of $110. That means he now needs a return of $105 on his $5 to reach $110. This requires a return of 2100% to reach that total.

So, both of these commenters vastly underestimated the damage done by a steep drop in share price. Thus, it is imperative to limit the risks of such a drop.

Managing Risk in the Market

How can you manage risks? I use three strategies for managing risk.

Although the stock market is inherently risky, you can ensure that no single position decimates your portfolio by keeping your position sizes small. My general rule is that no single position takes up more than 2% to 3% of my overall portfolio. That means even if a position goes bankrupt and shares go all the way to zero — and I have had that happen — it can only dent my overall portfolio by 3%.

I do make an exception in the case of most mutual funds, which are inherently already diversified. However, you do need to ensure that mutual funds that make up more than 3% of your portfolio aren’t highly leveraged or overly concentrated, because there are cases where such mutual funds themselves have gone bankrupt.

The second way I manage risk is to diversify. Every year, the sector performance in the S&P 500 can vary tremendously. In 2023, for example, the technology sector was up 56%, the S&P 500 Index was up 24%, but the utility sector was down 7%. If you want to manage your risk, you don’t want to overload any particular sector. Spread your bets across multiple sectors, and you should be OK.

Of course, there are times that all sectors are down. That’s part of the inherent risk in the market. You can ride out these declines as long as you adhere to my final rule for managing volatility: Don’t use leverage.

Your brokerage will be more than happy to loan you money to buy shares. But, in the case of a big market decline, you may find yourself getting margin calls. If that happens, your shares could be sold out from under you, which removes your ability to ride out volatility.

Follow these rules, and you should build wealth over time, without undue risk. You may not get rich quickly, but you will get rich — without finding yourself in a deep hole from which you may never recover.

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