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.
But before
we get to the meaty portion, let’s discuss some important concepts you can’t take
for granted.
Read further. See The Difference between Risk and Volatility
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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