The Biggest Key to Safely Speculating In Natural Resource Stocks
***By most accounts, the first case of an audience throwing tomatoes at a performer was reported in the October 28, 1883 edition of The New York Times.
The paper reported how an acrobat named John Ritchie was pelted with tomatoes after disappointing a crowd in Long Island. Ritchie purportedly fled for the stage door through a “perfect shower” of tomatoes.
Throughout the years, audiences have thrown other foods, like eggs and turnips, to express displeasure over a performance. But for some reason, the tomato became the protest food of choice. It’s how the world’s most powerful movie review website, Rotten Tomatoes, got its name.
***Like it or not, we are all performers in one way or another. We are all trying to satisfy or entertain somebody. Even as a fund manager and as Chief Investment Strategist of Katusa Research, I’m on a stage–a public one at that–performing for investors. And like any performer, I’ve had tomatoes thrown at me.
It doesn’t take long to become a target in the investment business. Successful investing is a task where the difficulty is on par with brain surgery. The financial markets are astonishingly complicated. Even the best guys can’t help but make embarrassing mistakes. For example, google “Warren Buffett mistakes” and you’ll find thousands of articles about the legendary investor’s missteps.
But today, I’m not going to talk about the mistakes of famous investors.
Today, I’m going to talk about you.
We’re going to discuss the most common–yet most misguided–source of investor anger and nasty letters at every research firm.
You might be making this mistake yourself.
What I’m going to say will sound critical. But there’s a big benefit for you in all this. If you learn why this source of anger and criticism is so misguided, you stand to become a much better investor. This is “master’s level” knowledge that will vastly improve your results.
***With that said, here is the most common–and most misguided–source of anger and nasty letters among investment research consumers.
The comments you see below differ in wording, but they come from the same source:
“What you said about ABC Stock didn’t happen. You are the dumbest SOB on the planet. Because of my losses in ABC, I can’t retire.”
“I can’t believe ABC Stock didn’t work out. I put everything into that stock. You’ve ruined me.”
“You were wrong. ABC Stock didn’t go up. It went DOWN. I had half of my portfolio in that stock. You’re worthless. Your company is worthless. I’m screwed now.”
***Around the world, investment managers and financial analysts who read those words are nodding their heads in acknowledgement. They know exactly what I’m talking about.
Because one single stock recommendation didn’t work out, normally polite, normally reasonable people will insult you in ways that would shock a member of the Hell’s Angels. Because one single stock you recommended went down instead of up, a nice little schoolteacher from Kansas City will say the worst things in the world about your mother. An unsuccessful stock pick will make people say truly awful things to you.
These kinds of comments come from a common source: Ignorance of what truly leads to a lifetime of successful investment.
In fact, these comments reflect what is perhaps the greatest difference between successful investors and investors who always struggle with investing and lose money in the market.
The unsuccessful investor regularly places 100 times too much importance on what happens with a single stock position.
Because he gets so excited and emotional about the prospects of individual companies, the unsuccessful investor makes critical position sizing mistakes. This harms him every single year…and kills his returns over his career.
***Position sizing is the part of your investment strategy that dictates how much of your portfolio you place into a given stock, bond, fund, or commodity.
For example, suppose an investor has a $100,000 account. If he buys $2,000 worth of stock in a company, his position size would be 2% of his capital. If he buys $5,000 worth of stock, his position size is 5% of his capital.
Position sizing is far, far more important to your success than any one single stock position. You could think of your investment career like going on a road trip. Position sizing is as important as having tires on the car. The result of any one single stock position is as important as the color of the hood latch.
Yet many investors go their whole careers without developing even a working knowledge of this critical factor. And many people who actually do think about position sizing think about it all wrong…
Many people think of position size in terms of how many shares they own of a particular stock. But it’s much, much smarter to think of it in terms of what percentage of your total capital is in a particular stock.
***Position sizing is the most important way investors can protect themselves from what’s known as a “catastrophic loss.”
A catastrophic loss is the type of loss that erases a big chunk of your investment account. It’s the kind of loss that destroys retirement accounts…and even marriages. I’m talking about a loss that leads to a $250,000 account plummeting to $100,000 or $50,000 in value.
The most common cause of catastrophic losses is going “too big” on risky positions. This occurs when an investor takes a much larger position size than he should. He’ll find a stock he’s really excited about…he’ll start thinking of all the profits he could make…and then he makes a huge bet. He’ll place 30%, 40%, 50%, or more of his account in that one idea. He’ll go for broke and buy 6,000 shares of a stock instead of a more sensible 1,000 shares.
If the position doesn’t work out, he can suffer a 50% hit to his capital. In some cases, he can suffer a devastating 100% loss of capital.
For example, some Enron employees put all of their retirement money in the company’s stock…and then lost everything when it blew up.
Those people made horrible position sizing mistakes by risking everything on just one stock.
The obvious damage from a catastrophic loss is financial. An investor who starts with $100,000 and suffers a catastrophic 80% loss is left with $20,000. It takes most people years to make back that kind of money from their job.
The less obvious damage from a catastrophic loss is worse than losing money. It’s the mental trauma that most people never recover from. They consider themselves failures. They see years of working and saving flushed down the toilet. Most never recover. Imagine someone spending 10 years scraping together $80,000 only to blow it all in 10 days by gambling on risky stocks.
I’m telling you all this to emphasize a simple point: Avoid the catastrophic loss by carefully sizing your positions!
***Generally speaking, most top investors will never put more than 5% – 10% of their account into any one position. Some professionals won’t put more than 3% in one position. My personal limit is 10%. Skilled investors can vary their position size depending on the particular investment.
For example, when buying a blue chip stock that has increased its dividend payment for 30 consecutive years, a position size of 5% – 10% makes sense.
When dealing with more volatile vehicles like small cap resource stocks, position sizes should be smaller. I suggest that you never put more than 1% of your wealth into a single resource stock. This will keep your risk level at an acceptable level.
Put another way, before you start speculating in junior resource stocks, you should know how much money you want to allocate to the sector as a whole. This should be money that you can lose without it affecting your lifestyle. Never allocate more than 10% of your junior resource portfolio into any one stock.
Unfortunately, many investors will risk three, five, or ten times as much as they should. It’s a recipe for disaster if the company they own suffers a large unforeseen decline. These large declines happen with much greater frequency than most folks realize. No matter how promising a company sounds, its fortunes can always turn south. Smart position sizing will keep the damage it causes to an acceptable minimum.
I like to get as excited about a company’s prospects as anyone. I love analyzing balance sheets and visiting projects. I love taking a stake in a small company and watching it achieve success.
But here’s the thing…
I never lose sight of what is truly important for achieving long-term investment success. And that is making sure I’m not exposing myself to catastrophic losses.
Successful investing is a marathon. It’s not a sprint. Building long-term wealth for your family comes down to regularly making intelligent decisions that provide a good balance between capital growth and capital safety. It does not come down to rolling the dice and “going big” on a single stock.
***As the Founder and Chief Investment Strategist of Katusa Research, I will make mistakes. Only frauds would claim otherwise.
We find stocks with huge upside potential. But we follow a time-tested approach used by the greatest investors throughout history. We never bet the farm on one position. We play great defense. Our winners more than make up for our losers. Over the long run, this approach will allow anyone to grow their wealth.
Your number one job as an investor is “don’t lose money.” Smart position sizing will help you do your job well.
The next time you feel rage or despair over what one single stock is doing, take a deep breath. Take a long walk.
Ironically, the same goes if you miss out on a stock. Don’t worry. Be an alligator speculator. Don’t chase the stocks. Be patient and wait for a market correction to happen; they always have, and they always will. And if you do miss one stock, don’t worry–there will always be a new idea coming to you shortly.
Then, with a clear head, review your position size. Review your portfolio. Ask yourself, “Am I taking insane risks? Does this position make up far too much of my portfolio? Is my anger or despair an indicator that I’m doing this all wrong?”
If you think the answer to these questions is even “possibly,” it’s probably time to reduce your position size. Cut it by at least 50%.
Your net worth will thank you.
P.S. To see what I’m doing with my own money, you’ll want to become a subscriber to Katusa’s Resource Opportunities. I can’t make the trades for you, but you can learn from the bets I’m making. You can get started right here.