The importance of risk management
When investing -- as in every other area of life -- it is important to understand and manage risk. What is investment risk? Academics and Wall Street professionals often define risk as “volatility” in prices, such
as “beta”, which is a measure of the volatility of an investment relative to a benchmark such as the S&P 500.

However, we define risk as losing your hard-earned money and falling short of your financial goals, such as funding your children’s education or your retirement. Everyone has their own tolerance for how much risk they can take, depending on their net worth, income, expenses, age, etc. Thus, determining your investment risk tolerance is a very personal matter.

Once you’ve determined your risk tolerance in an investment -- which is how much money you’re willing and able to lose -- you can manage your risk by entering a stop-loss order on the investment with your broker. Stop-loss orders can help one prevent significant losses in an investment. A stop-loss order is a brokerage order to sell a designated number of shares of a stock or ETF if and when it falls to (or below) a certain price. We usually recommend stop-loss prices be set 5%-15% BELOW the purchase price of a stock or ETF and then raised as the share price rises. For example, if a stock is bought at $100 per share, a stop-loss order might be entered to sell the stock at a 10% loss, or $90. If the price rises to $110, the stop-loss order could be raised to $100 and so on.

The importance of diversification
Another important way to minimize unnecessary investment risk is to diversify your investments. In layman’s terms, this means not putting all of your eggs in one basket. This is particularly important when investing in individual stocks. Worst case example of NOT being diversified: employees of Enron who had their entire net worth invested in that one stock lost everything when it went bankrupt. Generally, it is wise to diversify stock holdings with at least 10 or 15 different stocks, ideally in different industries, in order to minimize the risk of something going seriously wrong with a particular company and its stock.

A key advantage of ETFs over individual stocks is that they do the diversification for you by investing in a large number of stocks, such as 500 stocks in the case of S&P 500 index ETFs. You can also buy ETFs to diversify across asset classes such as US and international stocks, bonds, REITs, commodities, currencies, etc.

For a detailed discussion of how to limit investment risk, please see our free Special Report titled “How To Invest For Bull And Bear Profits.”

It’s important to not focus solely on valuation metrics when determining whether to buy a stock or not, since...