5 Powerful Risk Management Tips for Starters

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Investing and trading are both inherently risky. If that statement is true, then you should know by now that risk management can make or break your career as an investor or trader. We’ll help you navigate through the plethora of risks you might encounter.

man holding a block showing risk management


But before we get to the meaty portion, let’s discuss some important concepts you can’t take for granted.


The Difference between Trading and Investing

These two terms have been  used interchangeably throughout your career as a trader or investor. And most people think that the two words are totally the same, and they point out to the same meaning. However, in spite of the apparently tremendous similarity between these two terms, it’s important to note some distinctions.

When one says that he or she is an investor, it’s possible that that person refers to long-term investing. These people are normally the ones who buy an asset and hold it for several months or even years.

On the other hand, an investor can also be aggressive and on the constant lookout for excitement in his trades. The word ‘trader’ may be more suitable to describe this kind of investor. Such person doesn’t typically hold a position too long. Many of his or her positions don’t last for more than a few months.

The reason why it’s important to distinguish which type you are—whether a plain investor or an aggressive trader—is that there are also differences when it comes to risk management strategies applied by an investor and by a trader. For instance, traders—short-term position holders—generally follow one rule: never place too much risk for a single trade.

How to Distinguish Between Active and Passive Investing

Now here’s another set of words we have to differentiate before we jump to risk management tactics.

When you’re an active investor, you basically try to outperform the market. And this market may be represented by an index or a benchmark.

In fact, most mutual funds are actively managed. Fund managers are the ones tasked to conduct market researches and trend analyses, along with studies of the economy and companies. They do these in order to provide relevant, timely, and useful information and insights to investors.

Theoretically, over-the-top research and analyses can help you outperform the benchmark or index, or the market. Fund managers believe that the market is inefficient, as opposed to the efficient market hypothesis, and so these people try to find ways to exploit anomalies and irregularities.

Meanwhile, if you’re investing passively, you invest in the same securities in the same proportion as an index (S&P 500, Dow Jones Industrial Average, etc). John C. Bogle, who created the first index fund in 1975, concluded that the actual performance of active mutual funds could be worse than comparable index funds. This is because of higher fees given to active managers.

Passive investors, obviously, believe in the efficient market hypothesis, which claims that the market is efficient. This means that the market prices are fair. Such prices, according EMH, reflect all available information. It entails the belief that it’s nearly impossible to outperform the market on a consistent basis.

Now that we have finished defining those crucial terms, it’s time for the tips for you to get ahead in your investing career.

Do Not Go for Broke

This sounds like a matter of common sense. However, newer traders still tend to follow the all-or-nothing logic. We advise all traders, even those with small accounts, to not adopt strategies where they don’t fully understand the risks.

Do not just let your money go out the window without any definite strategy to return your account to a reasonable level. It would be much better if you stick with this outlook: stay in the game as long as you can.

In other words, any of your losses should be affordable. Don’t risk anything you can’t afford to lose. If you trade equities, limit your risks by setting a specific number of dollars invested per trade.


Position Size

As mentioned earlier, the rule of thumb is not to put too much risk on a single trade. In the same manner, you should not invest too much money in a single trade. That’s a really poor strategy.

Don’t be tempted if the investment looks too attractive. One expert once said that “if something’s too good to be true, it probably is.” You must learn to follow the examples of investing legends.

This one’s especially applicable to new option traders, since a huge number of them believe that out-of-the-money options can be sold with nearly zero risk. In fact, many option traders have gone out of business because they have sold too many of those options.

This tip should be remembered by both traders and investors. Trade with the appropriate position size and you’re one step closer to being an accomplished risk manager.


Accept Losses

We don’t really try to avoid losses. What we do is try to minimize such sufferings. There will always be times when you don’t know better, and it’s more than likely that you’ll lose something. Investors and traders are bound to lose something, but that doesn’t mean we can’t lessen them.

For long-term investors, you will notice that the stock you own is not only struggling at present, but is also facing a dim future. Try to remember when you bought the stock. Why did you buy it?

When everything around you tells you that your trade will no longer be profitable, you’ll have to accept the fact that you lost something because of the stock. That’s always a better course of action instead of holding on and hoping against hope that the stock will perk up.

This is also true for short-term traders. If the position price goes against your plan, you are losing money. Of course, you had your near-term expectations, and you’ll have to face the reality that you didn’t meet them.


Asset Allocation

The idea behind this is to minimize risks by allocating your investment dollar among various assets. For instance, gold and stocks tend to move in opposing directions. If you have both of them in your portfolio, you’ll likely suffer less than if you only had one kind of asset.

The idea is to never put all your eggs in one basket. However, many investors do not have ample amounts of funds to spread their money among a wide variety of asset classes.

What you can do is to allocate by owning stocks in different industries. Then, also own some stocks that pay high dividends.

As for traders, they do not have much of their capital at any single time. Each position must be watched closely, so one or two positions are usually the limit. This means that most of their assets are in cash and that should be enough to limit losses.

Learn more about diversification. See the Advantages of Portfolio Diversification

Trade Plan

As an investor, you should have a trade plan that’s not too complicated. The idea is to put into writing the specific rationale of your trade. What are your objectives? At what rate do you expect your investment should grow? At which time will you consider that you made a mistake in your investment? These are just some of the most crucial questions your trade plan should answer.

Of course, it would take quite some time before you can see your trade plan making sense for a specific stock. However, you don’t have to stay committed to a business that has repeatedly underperformed.


Conclusion

Many things happen in trading and investing, and there will never be one sure way to prevent risks. Just like what we said above, you cannot completely remove risks. You can only lessen it. And the best way to mitigate risks is to know how much risk you can tolerate. Assess you capacity to endure such risks, and then dig deeper on the best ways to manage them.



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