Highly volatile stocks can come with significant risks, especially if you think you’ve found a “can’t miss” indicator that leads you to buy them

The more I looked into investor rules throughout my career, the clearer it became that the best ones were not delivering consistent value for investors, and the worst ones were increasing investor risk. The problem is that an investment indicator uses only a tiny fraction of all the information that can have an impact on the price of an investment. You may think your favourite indicator zeroes in on all the key factors you need. You may be right, of course, but there are many ways to go wrong.

What you’ve done is introduce a random factor into your investment decision making. Any given use of a random factor can work for or against you, and can have a significant impact when it involves highly volatile stocks.

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Back testing market indicators aims to prove their worth. But testing is usually highly selective, and it typically won’t help you—especially with highly volatile stocks

One clear problem is that the outcome of using a rule depends on when you use it. If a rule spurs you to buy (a particular kind or stock, or the market as a whole), it will work best (if at all) when prices are rising. If it spurs you to buy when prices are falling, it will work against you. It might spur you to make investments that generate above-average losses.

That’s a particularly big risk with a highly volatile stock, since it can multiply the impact of bad decisions.

Most investor rules come into being through “back testing” of some observed market tendency, which may start out as a hunch. The originator of the rule goes back to see if it paid off or not during some historical period, such as the past five or 10 years. However, due to the random factor, you can get a totally different result if you back test periods with different start or end dates.

The more I looked at the way market rules performed in various periods, the clearer it became that their results were largely random. Sometimes they “worked” (made money for users) and sometimes they didn’t. A rule could back-test well during one five-year period, but cost you money in the previous five years, or the next five.

Worse, sometimes all of the profits from a given rule occurred during a standout performance that only lasted a year or two, or less…even just a few months or weeks.

In fact, when you let random factors play a role in your investment decisions, you’re lucky to achieve average performance.

Keep aggressive investments, like highly volatile stocks, to a smaller part of your portfolio

Our stock selections for aggressive investors tend to be more highly leveraged and more volatile than the conservative recommendations that form the core of our Successful Investor approach. Those aggressive selections can give you bigger gains, and bigger losses. This may be due to financial leverage, or to the risk in their industry or particular situation, or to upcoming changes we foresee in the level of that risk. Keep in mind that these or any aggressive investments should make up only part of most investor portfolios.

If you want to diversify your portfolio with speculative or highly volatile stocks, you must first understand the chances you’ll take. They’re only suitable for investors who can accept substantial risk. You can be wrong on any of your stock picks, of course. But when you’re wrong on speculative or highly volatile stocks, losses are likely to be larger than with a well-established company that fits into our Successful Investor philosophy.

Zeroing in on a handful of aggressive stocks can pay off nicely when it works, but it can be extremely costly when you pick too few winners and/or too many duds.

But that doesn’t mean you should avoid aggressive stocks altogether. We recommend limiting your aggressive holdings (assuming that these holdings represent sound investment value). This is because aggressive stocks expose you to a greater risk of loss.

Spread your money out while investing in highly volatile stocks to minimize risk

No matter what kind of stocks you invest in, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.

Use our three-part Successful Investor approach when investing, especially when deciding how much to put into highly volatile stocks

• Hold mostly high-quality, dividend-paying stocks.
• Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
• Downplay or stay out of stocks in the broker/media limelight.

How do you determine which level of volatility to take with your stock investing? Has this changed over your investing career?

What kind of performance have you experienced from aggressive and volatile stocks in your portfolio?