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2 Rules for Controlling Risk in Growth Investing

Controlling risk in your portfolio is important to avoiding the big losses that can sap your results.

Controlling risk in your portfolio is important to avoiding the big losses that can sap your results.

For most people, risk control means diversification. You’re taught to have some assets in growth stocks, value stocks and income stocks. Investment texts tell you that your stocks should also cover the spectrum from large-cap stocks to small-cap stocks.

But you don’t get much advice about how to allocate the money within each category of stocks. Today I’m going to tell you how you can reduce your risk in your growth portfolio.

The more holdings you have, the lower your risk. If you have 50 holdings, it will be hard for the failure of any one of them to deep-six your results.

The problem is that it will be correspondingly difficult for a big rally by one of your stocks to make you a lot of money. For maximum results, you need a concentrated portfolio. Cabot Growth Investor—which is considered to be moderately aggressive—is fully invested when it has 12 stocks in the Model Portfolio. Cabot Global Stocks Explorer is even more aggressive, with a hypothetical portfolio of just 10 stocks when it’s fully invested.

If you decide to go with this kind of concentration in your growth portfolio, you need to follow two rules to keep risk under control.

First, you must set loss limits based on the price at which you bought each position. When markets are challenging, your sell discipline should kick in at a minimum of 15% below your buy price. No exceptions. When markets are supportive, you can push that loss limit to 20%. The limits kick in only at the close of a trading day. Intraday moves don’t count, unless a stock is clearly in free fall after bad news. In that case, the quicker you get out the better.

The second risk rule is to use equal dollar positions to build your portfolio. The number of shares you own is totally irrelevant. If you are working on an aggressive portfolio, you should divide the amount of money you have allocated to that portfolio into 10 equal-dollar positions and buy just that amount of each stock. Having 100 shares may be neat, but if you have 100 shares of a stock that trades at 25 and 100 shares of one that trades at 50, your risk exposure in the second stock is twice a big.

Two great building blocks for a sound growth portfolio: Loss limits and equal dollar positions.

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Growth Investing involves a greater degree of volatility than dividend or value investing, but it has the potential for bigger rewards. Find out how.

Paul Goodwin is a news writer for Cabot’s free e-newsletter, Wall Street’s Best Daily.