Successful investors never “go for broke,” as the saying goes. Instead, they try to arrange their portfolios so that they profit more or less automatically over long periods. You do that by tapping into the long-term growth that inevitably comes to well-established companies when they operate in relatively free economies during relatively prosperous years and decades.

To do this, start by following our three-part investing philosophy. First, invest mainly in well-established companies, since they tend to continue to prosper over long periods. Second, diversify across most if not all of the five main economic sectors. Third, downplay or avoid stocks in the broker/media limelight, where high investor expectations tend to expand risk.

Note that our stock market advice automatically limits your involvement in notoriously trouble-prone areas like new issues, start-up companies and illiquid investments. (That is especially true of heavily-publicized new issues like Facebook, which I advised against on May 11—See Pat’s YouTube post “Should Investors Buy Facebook New Shares?” here.)

Of course, you also need to stay out of companies when you have doubts of any sort about the integrity of insiders.

You need to recognize the special risks of investing in fashionable or excessively popular minefields, such as Internet stocks in the late 1990s, or income trusts in the previous decade, or green energy in the current decade. We try to alert you to these kinds of risks in our publications.

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How simple arithmetic works against big risk-takers

Rather than avoiding high-risk areas, however, many beginning investors feel drawn to them. That’s because trouble-prone areas always manage to give some investors the mistaken impression that they can generate big and easy profits. Unfortunately, the risks are even bigger.

When they are just starting out, many investors believe they can afford to take big risks with their money. After all, if they lose money, they have decades to break even. But they overlook the way that simple arithmetic works against you when you take on too much risk.

If you lose 10%, you need an 11% gain to break even.

If you lose 20%, you need to make 25% to break even.

If you lose 40%, you need to make 66.6% to take you back to where you started.

If you lose 50%, you need a 100% gain to break even.

An 11% gain is relatively common; in fact, the market has gained nearly that much annually, on average, over the past 75 years or so. A 25% gain is a little harder to achieve. You need an above-average year to make that kind of return.

Gains of 66.6% to 100% or more can take years. Even if you make enough money to regain your losses, however, that only brings you back to where you started. You’ve still lost some purchasing power to inflation. But in addition, you’ve lost the time value of your money. You’ve missed out on the compound profit you would have made on your original stake and your profits if you had invested more conservatively and made modest gains of perhaps 5% to 10% annually.

Of course, even the highest-quality, best-established stocks go down when the general market is falling. The difference is that top-quality stocks tend to recover and eventually go on to new highs. Meanwhile, they generally keep paying dividends.

COMMENTS PLEASE:

Success with a risky stock can bring a huge return, but many risky stocks bring losses instead of profit. Have you ever tallied up the results of all your dealings in risky stocks? How does your experience with risky stocks compare to your results with more secure, higher-quality investments? Let us know what you think in the comments section below. Click here.