Editor’s note: We’re rounding out our series of classics from Porter Stansberry with an important checklist that most investors overlook. In this updated excerpt from a DailyWealth essay – most recently published in 2018 – our founder discusses how to zoom out and cut back on risk across your investment portfolio.

The greatest investors in the world already know this secret…

It’s so simple, but it can make you a better investor overnight. It will transform a losing portfolio into a winner. And it has nothing to do with the stocks you buy.

It has to do with two ways to sleep well at night knowing your portfolio is prepared for anything that may come.

Here are the two things you should do this year (and every year)…

No. 1. Make sure you truly understand how much risk you’re taking.

I’m frequently astounded (and terrified) when I talk to individual investors and they start describing their strategies. A portly gentleman wearing overalls told me proudly at a Casey Research meeting once that he’d mortgaged his house to buy junior mining stocks. He wasn’t worried about the pullback (which became a grinding, four-year bear market and probably wiped him out) because he was diversified across more than 30 different tiny companies.

The best way, by far, to understand how much risk you’re taking in your equity portfolio is to use TradeStops.com. I don’t know of any other software system anywhere that allows you to easily (and automatically) enter your brokerage information and quickly receive an accurate assessment of the volatility of your actual portfolio.

TradeStops can tell you exactly how much risk you’re taking, both with your portfolio as a whole and across all of your individual positions.

My bet? If you’re managing your own portfolio, you’re probably taking at least twice as much risk as the S&P 500 Index. That is, if a bear market strikes and stocks fall 20%, your portfolio will most likely fall more than 40%.

If you don’t know how much risk you’re taking, you’re much less likely to guard against those losses. But if you do know how much risk you’re taking and which positions are the riskiest of all, you can do a much, much better job of running your portfolio safely.

By the way, if you use a broker or an asset manager, it’s even more important for you to have this tool and this information. Why? Because you’ll have a much better sense for whether or not he’s doing a good job… or just taking a lot of risk in a bull market. (Telling him where he’s taking too much risk will also let him know you’re not a knob.)

If you don’t have TradeStops or you won’t buy it, you can “spitball” this risk assessment by simply measuring the weighted average of the “beta” of your individual positions. A beta of “1” means that a stock has the same volatility as the market as a whole. A beta of “0.5” means a stock is half as volatile as the market. And a beta of “2” means it’s twice as volatile as the market.

You can generally find the beta on any security by using widely available databases, like Yahoo Finance. (Careful, though… sometimes the data are glitchy. So if you see a number that doesn’t make sense, check it using another source. Or… even better… just use TradeStops.)

Once you understand how much risk you’re taking, I suggest rebalancing your portfolio so that you take less risk than the S&P 500. Remember… you want to be cautious when others are greedy.

You can lower your risk by selling down risky positions and building cash in your portfolio. You can also lower your risk by adding hedges that have a negative correlation to the stock market, like short selling positions.

No. 2. Out of all the studies I’ve read about portfolio risk-management strategies, no tool is more powerful than risk-based position sizing.

In other words, whether you followed hard stops, trailing stops, or “VQ” trailing stops (which are based on a stock’s individual volatility profile)… the biggest improvement to portfolio performance came from using a position-sizing strategy that equalized the capital at risk in each position.

This year, give yourself the best chance at success. Rebalance your portfolio so that you’re risking the same amount of capital in each position. Again, you can do this with the click of a button by using TradeStops. You just link the software to your brokerage account, import your portfolio, then use the “Risk Rebalancer” to learn exactly how many shares of each position you should own. That way, you end up with the exact same amount of risk in each position.

This allows you to use wider stops on your riskier positions, because they will be far smaller positions than your safer stocks. And it lets you speculate in high-growth equities without taking on too much risk.

Again, if you don’t have TradeStops or aren’t willing to use it, you can approximate this approach by using each stock’s beta to adjust your position size. If a stock has a beta that’s less than one, then increase your position size until multiplying its beta by that factor will equal one. And do the inverse for stocks with betas that are greater than one. Doing so will give you a risk profile that’s equal to the markets. If you want less risk, then standardize to a beta of 0.99 or less, depending on how much risk you want to take.

The important thing is to make sure that you’re taking the same amount of risk in each position. Nothing else you can do this year is more likely to increase your portfolio’s return.

And yet… I’m certain that more than 90% of readers will completely ignore this advice. So ask yourself: are you really trying to become a better investor? Why not at least do the easiest thing, the thing that’s most likely to help you, first?

As I’ve said before, you also want to make sure you’re investing for the long term in high-quality, “capital efficient” businesses. That’s the best, safest, and surest way to get rich in stocks. But don’t neglect these two important steps.

I know hardly any of you will take these concepts to heart… Fewer will actually take action – even though it’s one of the simplest and easiest things you can do. But they can make you a fortune over your lifetime.

Regards,

Porter Stansberry

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Source: Daily Wealth