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Rule Breaker Mailbag: How Can You Really Tell the Winners From the Losers?

By Motley Fool Staff – Jul 20, 2017 at 6:58PM

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Listener Martin asks a question that really cuts to the heart of the Foolish investing philosophy: How do you limit the number of losers in your portfolio?

In this segment from Rule Breaker Investing, Motley Fool co-founder David Gardner tackles an interesting question: How can you tell winning stock picks from losers? Fools know that it's not so simple, but in this case, David refocuses the question to one of risk. His answer hinges on a good, Foolish risk rating. Lucky for investors, a low risk doesn't have to mean low reward.

A full transcript follows the video.

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This video was recorded on May 31, 2017.

David Gardner: Martin writes, "Hello, David! Thank you and your producer very much for your consistently excellent RBI podcast." I never give enough shout-out to Rick Engdahl, who does such a good job editing me and taking out all the mistakes that I make, that you never hear, every single week. That's one of the reasons I don't really want to do this podcast live in front of people -- because you'd see how often I screw up, but you never do because of Rick Engdahl.

Anyway, Martin goes on. "I'm an English teacher in Japan and a fellow English major, something I once heard Buffett, unfortunately, frown upon." I don't know that reference, but I chuckle a little bit at that. Anyway, you go on to say, "I enjoy listening to your podcasts every week as I drive to work deep through the Japanese countryside with your voice among the green rice fields, farmers on old bikes, and many temples. It makes for quite a colorful contrast -- one quite inspiring -- as I usually never meet any English speakers, here. Certainly not ones to talk about investing. I also always listen a couple of more times back at home and take copious notes." -- I'm definitely not worthy of that, Martin. You need to up your game. No, thank you very much -- "I've learned so much from your weekly gift to us. Thank you and please thank your father for me. I meant to send a thank you note to him on his birthday when you mentioned it a number of months back. I've been able to share your enlightened approach and insights on investing with many people, here, so its impact is truly global. I've also greatly benefited financially from your stock ideas, in addition to the RBI podcast, through going into more detail on investing in your book, Rule Breakers, Rule Makers, [and] subscribing to Stock Advisor and Rule Breakers." Wow, Martin you are the very model of a modern, major Fool. Thank you, sir.

And you close that paragraph with "Domo arigato" -- I'm really going to butcher this -- "gozaimashita." I'm not sure what we said, but I hope that was family friendly.

Now your final sentence. "I've thought for a long time a question to ask that would be applicable and helpful for the RBI audience. One question I think is worth always asking and reviewing is how one can determine the winners apart from the losers in the stocks that you like to focus and invest in. Thank you." Regards, Martin

Wow. That really cuts right to the nub, doesn't it? How do we separate our winners from our losers? I'm tempted to want to say, and leave it at this, that if I could do so, I would be a much, much better investor. But I think even though I have a lot of losers -- and I don't seem to be able to always recognize what's going to be wheat and what's going to be chaff -- I am going to give you one tool to think about, Martin. I know I'm speaking, here, to somebody who subscribes both to Stock Advisor and Rule Breakers, so I hope you'll avail yourself of a tool that lies within those services, and that tool is something I talk about every month or so on this show. And those are our risk ratings.

This is a tool that we developed a few years ago. It's a 0-25 point system for scoring the amount of risk inherent in any stock that we're talking about. The higher the score, the riskier the stock. So if a stock has a risk rating of 15, it is far riskier than a stock with a risk rating of 6. So I would highly suggest that if you're looking to avoid losers, that you probably tend to go with our lower-risk stocks.

One of the interesting things about our risk ratings is we've discovered over time that risk and reward do not correlate in as pure a manner as one might think. I think one of the shocking and brilliant insights that this tool has given us is that sometimes things that really are low risk actually have greater reward than those high-flying, overpriced things. [They] might be biotech and have a really high-risk rating that look exciting if they can just get FDA approval -- but then implode sometimes in our faces -- which we're still going to do, from time to time because that's what we do as Rule Breakers.

But my point is if you're really looking to increase the percentage of time that you get wins -- that you make money, that you beat the market -- I think our internal stats show that risk ratings five to eight, down in that range -- I did talk about this last year at one point -- those are the ways, I think, to increase your percentage of success if you are looking to avoid losers.

Just know that if you are looking to avoid losers, sometimes you'll miss some big winners because you had a reduced risk profile. And so that's something that I'm sure you'll understand -- and maybe you already knew this tool, Martin -- but for anybody who is a Stock Advisor or Rule Breakers member, you can see the risk rating for every one of our stocks that we cover and we tend to update those maybe once a year or so.

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