This is a Guest Post By Brian Hunt CEO of InvestorPlace

Of all the things that separate a great investor from the average losing investor, few can match the power of The 5 Magic Words A Great Investor Says Over and Over.

A great investor says The 5 Magic Words – or something like them – every single time he or she is presented with an opportunity to deploy capital.

The average guy?

He doesn’t even know The 5 Magic Words… and his ignorance costs him dearly.

These 5 Magic Words apply to all investments. Real estate, venture capital, blue chip stocks, bonds, natural resources, private business, you name it.

So, what are these 5 Magic Words that can be the difference between a life of financial independence or a life of financial struggling? Here they are…

How Much Can I Lose?

Most every investor – both new and experienced – focuses 100% on making money… the upside of investments. They’re always thinking about the big profits they’ll make in the next great tech stock or in their brother’s new restaurant or some speculation.

They don’t think for a second about how much they can lose if things don’t work out as planned or if the best-case scenario doesn’t play out. (And the best-case scenario usually doesn’t play out.)

The intelligent investor is always focused on how much he can lose money on a stock, a private deal, a trade, a bond, or a piece of property. He is always focused on risk.

We’ve found, through years of investing our own money and studying very successful businesspeople and great investors – that when presented with an idea, the great investor reflexively asks early in the discussion, “How much can I lose? What happens if things don’t go as planned? What’s the downside?”

As we said, The 5 Magic Words apply to real estate deals, small business investments, public stock purchases, and dozens of other situations. The concern should always be, “How much can I lose? What happens if the best-case scenario doesn’t pan out?”

Only after these questions have been asked… Only after the risk has been measured and addressed, can we move on to the fun stuff… making money.

Unfortunately, the novice investor never asks these questions or thinks about the worst-case scenario. He never plans for it, doesn’t know how to handle it, and far too often, gets killed.

What do smart investors do instead?

Warren Buffett is probably the greatest business evaluator of all time… the greatest capital allocator to ever live. He’s worth over $50 billion because of his ability to analyze investments.

When they ask Buffett his secret, he doesn’t talk about the intricacies of balance sheets or cash flow analysis. He says the first rule of investment is “Never lose money.” He says the second rule is “Never forget rule one.”

In other words, Buffett’s rules are totally concerned with risk, not reward. The first thing he recommends to folks who want to make money in the market is to not lose money in the market. He’s obsessed with finding out how much he could potentially lose on a stake. Once he’s satisfied with that, he looks at what the upside is.

Now take Paul Tudor Jones, one of the all-time great short-term traders, with a net worth in the billions. Jones’ interview in the fantastic book, Market Wizards, is one of the most important things any empire builder can read.

Jones’ interview is filled with statements suggesting he’s a man obsessed with not losing money. Reading his interview will take you less than 10 minutes… and it might be the greatest “time put in versus value received” proposition an investor or trader will ever get.

You’ll find that for a guy associated with “winning” so much money, Jones constantly talks about losing… he constantly talks about playing great defense. There’s a comment on defense on nearly every page of Tudor’s famous interview. Here are the best ones:

*Don’t focus on making money. Focus on protecting what you have.

*I know that to be successful [in trading], I have to be frightened.

*I am always thinking about losing money as opposed to making money.

*Risk control is the most important thing in trading.

*Never play macho man with the market.

*The most important rule of trading is to play great defense, not great offense.

Tudor says the most important rule of trading is playing great defense, not offense. Tudor’s quote is the trader’s version of Buffett’s investment quote.

If a would-be financial empire builder taped Buffett’s quote in a place he’d see it every day… and if he read Tudor Jones’ interview once per month… and if he learned to reflexively ask himself, “How much can I lose?” before buying any asset, he would set himself up for a lifetime of making sound empire building decisions.

It’s one thing to point toward the importance of not losing money. It’s another to understand the mechanics that help us achieve this goal.

So, how do smart investors limit their losses?

In addition to focusing on paying bargain prices for your assets, the concept of position sizing is a great friend in the pursuit of not losing money.

Position Sizing: Your Defense Against the Catastrophic Loss

Position sizing is the part of your investment strategy that dictates how much of your investable assets you will place in a holding.

Many folks think of position size in terms of how many shares they own of a particular stock or investment. But the empire builder thinks in terms of what percentage of his or her net worth is in a particular holding.

For example, suppose an empire builder has a $500,000 net worth. If this investor buys $5,000 worth of a business, his position size would be 1% of his total capital. If the investor bought $50,000 worth of the business, his position size is 10% of his total capital.

Position sizing is one of most important ways you can protect yourself from what is known as the “catastrophic loss.”

A catastrophic loss is the kind of loss that erases a huge chunk of your net worth. It’s the kind of loss that ends careers and ruins retirements.

Most catastrophic losses occur when an investor takes a much larger position size than he should. He’ll find a stock he’s really excited about, he starts dreaming of the potential profits, and then he makes a huge bet. He’ll place 20%, 30%, 40% or even 100% of his account in that one idea. He’ll “swing for the fences” and buy 2,000 shares of a stock instead of a more sensible 300 shares. When the investment doesn’t work out, he gets killed.

The direct damage caused by the catastrophic loss is financial. An investor who starts with $100,000 suffers a catastrophic 80% loss is left with $20,000. It takes most people years to make back that kind of money.

But the less obvious, indirect damage is worse than losing money. It’s the mental trauma of taking such a huge loss… and feeling like a failure. Some people never recover from it. They see years of hard work and savings flushed down the toilet.

For example, many Enron employees suffered catastrophic losses when the company went bankrupt in 2001. They kept all or most of their retirement account in Enron stock. They “bet the farm” on one horse (which turned out to be a loser). They made grievous position sizing errors.

Most top investors will say never put more than 4% or 5% of your account into any one position. Some professionals won’t put more than 3% in one position. One percent, which is a much lower risk per position, is better for most folks.

Seasoned empire builders vary position sizes depending on the particular investment. For example, when buying a safe, cheap dividend stock, a position size of up to 5% may be suitable. Some managers, who have done a lot of homework on a stock and believe the risk of a significant drop is tiny, will even go as high as 10% or 20% – but that’s more risk than the average person should take on.

If you’re investing money into a startup business, a speculative stock, an option position, or anything else on the riskier end of the spectrum, the answer to “How much might this investment lose?” is usually, “Every single dollar.”

That’ s why speculative situations are best played with tiny amounts of capital. Or if you’re a conservative empire builder, not played at all.

But… let’s say you just have to invest in a speculative situation. Let’s say you’re buying a speculative gold-mining stock or a speculative tech company with just one potential “big hit” product.

With speculative investments, there is always the possibility that you could lose 100% of your money. So, you want to use a tiny position size.

Generally, you don’t want to place more than 0.5% or 1% of your net worth into a speculative investment.

That way, if the situation works out badly, you only lose a little bit of money. You’re easily able to recover. As importantly (and as we addressed above), you’re not emotionally scarred – fearful of dipping your toe back into the investment markets. After all, some burned investors build back up their capital base, but never recover the confidence to put their money back into the markets.

To avoid being burned like this yourself, you certainly don’t want to put 5% or 10% or 25% of your net worth into a speculative investment. It’s way too big and way too risky.

Unfortunately, most novices will risk three, five, or ten times as much as they should in speculative investments. It’s a recipe for disaster. If investment doesn’t work out as planned, or when the broad stock market suffers a big correction, a big position in a speculative investment causes a massive hit to a person’s overall wealth.

When in doubt, always dial down your position size. It will help you follow Warren Buffett’s and Paul Tudor Jones’s most important rule… and it will help you avoid catastrophic losses.

When you start on the empire building journey, you’re at the point of greatest risk – in danger of making self-damaging investment choices. So, take legendary speculator Bruce Kovner’s advice and “under trade, under trade, under trade.”

Make much smaller investments than your emotions want you to make.

Make small investments to get the hang of things. If you have $10,000 to get started as an active investor, set aside $7,000 and invest with $3,000 for the first six or 12 months.

Summing Up

The next time you’re thinking about making an investment or a trade, delay thinking about the upside for a while. Think about the potential downside first. Follow the example of legendary investor, Warren Buffett. Once you focus on protecting your downside, the upside will take care of itself.

Next time, I’ll describe how becoming a connoisseur of extremes is essential for investment success.

Regards,

You can see more work by Brian at InvestorPlace.com.