Many traders use a rule of thumb of betting no more than two percent of their capital on any single trade. The logic seems reasonable: keep your losses small and save your ammunition for big winners. Sounds good, but does it work?

The answer is yes under the right conditions. Unfortunately, the rule implies that you could afford to lose 100% of your 2% stake on every losing trade and still survive. This is not true. Let's suppose you were making trades that were successful 50% of the time. You'd have to make an average of 100% on your winning trades just to break even. That doesn't sound very easy to do. Moreover, by making small bets, you'd have to win much more than 50% of the time to make any real money. So there's got to be a better way to manage risk. That's what Stop-Prices are all about.

Stop-Prices allow you to increase you're stake in any given trade and still manage risk. But you still need to know what you're doing. For example, if you bet 100% of your capital on "a sure thing," you must use a two percent Stop-Loss to meet the trader's guideline. But even that wouldn't satisfy me. I wouldn't bet 100% of my capital on anything. Actually, you should never put more than 10% of your investment capital into a single position and use a 10% or lower Stop to go with it. This controls your risk of loss on any single position to one percent of your capital.

If you desire to use a wider Stop-Loss to improve trading performance, you must, decrease your stake in each position or decrease the percentage of capital employed. Here's how it works:

If R = Percent Risk of Loss on any single position,
C = Percent of Capital Employed,
N = Number of positions, and
S = Stop-Loss Percent, then
S = (100 * R * N) / C.

When we went long with Contra ETFs in our Model Portfolio on January 30th, we deployed 25% of our capital with five positions and a Stop-Loss of 10%. What was R, the risk of loss on any single position?

R = (C / N) * (S / 100).
R = (25 / 5) * (10 / 100)
R = 5 / 10 = 0.50%.

An examination of our Model Portfolio shows that we lost 3.04% in that campaign with two winners and three losers. Had we gone long with 100% of our capital and the traditional 10 positions and 10% Stops, the damage to the portfolio would have been much worse. Thank you, Risk Management.

Last week I wrote, "I don't think a buy and hold strategy is the complete answer to mitigating risk." This statement was made in light of the data which showed that the holding period, i.e., time, is a major factor in generating profits in the stock market. While I do believe the holding period is an important factor in turning profits, (VectorVest has demonstrated it hundreds of times in our performance tests of high VST stocks), there's a lot more to managing a portfolio than simply waiting for it to go up.

The first thing one should do when building a solid stock portfolio is pick the right stocks. Although this sounds trite, it's something that must be done. Stock selection is covered in Chapter 12 of my book, "Stocks, Strategies and Common Sense." Simply put, one should start out by selecting safe, undervalued stocks that are rising in price. Pick a variety of high Relative Value, high Relative Safety stocks with steadily rising prices. Review my essay of 08/04/06, Shopping for Bargains. Study the graphs of high RS stocks and look at the phenomenal earnings performance these companies have had. Exemplary earnings performance is the key to picking long-term winners.

So, when would you sell one of these guys? There are two things I watch very carefully. First, of course, is price performance. If a stock's price starts to fall while the market is going up, something is going wrong and it's probably earnings. So EPS is the second thing to watch. Unfortunately, it is not easy to spot an earnings problem ahead of time. Take Chico Fas, CHS, for example. Its price peaked at $48.90 on February 21, 2006, then it started going down. Was there a problem? Its EPS graph looked a little shaky, but the stock's price was doing fine. When Chico's price dropped $6.40 a share on six times normal volume on March 2nd, however, it was time to consider selling the stock. It closed at $17.95 yesterday and its graph of EPS and GRT shows the reason why.

VectorVest puts a Stop-Price on every stock and it shouldn't be ignored. Take Enron, for example. Its price peaked at around $90 late in 2000, then bounced up and down for several months. It finally broke below its Stop-Price of $68.20 in the Spring of 2001, got an "S" rating, and made its final descent. Its financial data looked terrific, but it kept going down and getting more sell signals as the months went by. The bad news finally started coming out at about $20 a share. There was still time to get out with something, but, as you know, a lot of people didn't. The company, which had won all kinds of praise from Wall Street Wizards, went bankrupt and its price fell essentially to zero.

This is why you never want to dollar average while a stock's price is going down. And please, diversify your holdings, even if it's company stock. Many years ago I suggested to a Microsoft employee that he put at least a third of his fortune into Treasury bonds. He has thanked me profusely since then.

The buy and hold philosophy has many, many advocates and it has a wonderful ring to it. But it's a risky strategy unless you start out with good stocks. Therefore, risk management, knowing when to sell, diversification and asset allocation are equally important. Patience is a key ingredient to making money in the long-term, and I wish I had more of it. Combine good stocks, risk management and patience and you'll make profits.

Next week, I'll write more on Risk, Patience and Reward II.