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Avoiding the Money Abyss From Which There is No Return

"How far is it to the bottom?"

My father and I did a lot of backpacking when I was young. These are some of the fondest memories I have of my father to this day.

Often when we were on a trek, we’d traverse rocky and dangerous terrain, following ridges and even cliff lines. For some reason, I always had the tendency to be drawn to the edge—I liked to see what was at the bottom of the ravine or canyon.

This concerned my father greatly. “If something happened to you, your mother would never forgive me,” he always said. And, he advised me to stay away from the edges.

I’m grateful for my father’s advice. But staying away from the edges isn’t always the most useful tactic if you’re trying to ascertain your position in the middle of the wilderness. Sometimes, you have to get near the edge to see where you are going, what lies ahead, or what you are up against.

You gotta be prepared, and know how far you can fall if you make a mistake. And if you know the risks involved, you are more likely to take better care.

Investing is like this, too.

Focus on Risk, Not Reward

You’ve probably seen numerous advisory services advertising the next hot stock pick. Some advisories and pump-and-dump schemes will claim they have the secret to the next big market move, or that they know which penny stock is going to the moon. And it’s going to make you a fortune if you SUBSCRIBE NOW and BUY BUY BUY.

If you don’t have experience with this, here’s how it goes: You immediately begin mentally spend the money you’re about to rake in, as you ask yourself the following question: “How much money will I make?”

I can’t begin to tell you how fundamentally wrong this is.

I was at a job interview once that felt like a monologue. Usually job candidates are expecting to sell themselves to the company, not the other way around. The company’s manager talked at me for about an hour about the company’s benefits and perks, glorifying the lifestyle I could have if I sign on with the company. Once I’d had enough, I asked him politely, “So, what can you tell me about this job that you think I will hate?”

He proceeded to explain that most employees work 70-80 hour weeks their first few years, among other pleasantries. I didn’t take the job. Not that I was afraid of work, more that I just didn’t want to deal with the risks involved.

Any time someone tries selling you on just the upside--please make sure red flags are going off in your mind.

5 Magic Words to Transform Your Mentality

Any time you considering investing in something new, rather than focusing on the upside potential, you need to take the contrarian position and ask yourself: “How much can I lose?”

In other words, what happens if my best-case scenario doesn’t work out as I think it will?

Once you have the answer to this question, and only if you can stomach the results (if the investment fits your risk appetite), should you ever proceed with an investment.

Ideally, the risk-reward spectrum should be something like 4-to-1. In other words, the amount you can gain should be four times greater than the amount you are potentially risking. Higher ratios are desirable, but not always possible.

The bottom line is, don’t bet the rent money. In other words, don’t ever risk any more than you can afford to lose. In fact, don’t ever risk money that you will miss.

Not all investments are going to work out. No one has a crystal ball to predict the future. The best thing you can do is use position sizing and stop losses to limit your losses to small, as opposed to catastrophic.

A good rule of thumb is that no single conservative investment should make up more than 4-5% of your overall portfolio. If you follow this rule, and set stop losses of 20-25% of the overall investment, you are looking at losses of no more than 1-1.25% of your overall portfolio. Anyone can recover from a loss like that.

For more speculative positions, which carry much more risk, a reasonable standard would be a position of no more than ½ or 1% of your overall portfolio. And typically we see stop losses on speculative, or volatile positions of around 50%, so the maximum loss would be around ¼ to ½ of a percent on even a very risky position. A few ham sandwiches for lunch in any given month.

To sum up:

Determine position sizing (how much money you will invest)
Determine your trailing stops (where you will sell if the investment loses money)
Ask how much you can lose, given the above
Ask how much you can potentially gain
If you are comfortable with the risk-reward setup, proceed to invest

Stick to this process. You’ll find yourself sleeping well at night, hopefully waking up to greater wealth and more prosperity in your future.

Live long and invest,

Jeremiah

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