HOW TO MANAGE RISK
AS A TRADER OR INVESTOR

Risk management plays a crucial part in optimising returns. It can help you minimise losses on losing trades, and protect returns on winning ones. This is how to incorporate effective risk management into your trading decisions.

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Interested in how you can manage risk as a trader or investor? Learn what risk management is and how you can manage risk effectively as you trade or invest.

What is Risk Management?

Risk management is the process of making investment decisions which influence how your portfolio will react to market events. It is typically associated with reducing the chances of losses being made, but can involve designing portfolios to take on a greater amount of risk.

Risk management involves knowing as much as possible about the risks involved with a certain transaction or position and expecting the unexpected.

Learn more about risk management and what you need to know as a trader or investor with our educational video on managing risk.

Risk management is not just about lowering risk, it is about knowing as much as possible about the risks involved with a certain transaction or position.

Risk comes from not knowing what you are doing.

Warren Buffett

How to Manage Your Risk

There are three key factors that need to be considered when managing risk. Considering each element separately can help you develop techniques which ensure your portfolio has risk levels which suit your personal profile. The three elements of risk are:

1. Knowledge
2. Concentration
3. Asset type

Knowledge relates to how well you know and understand the asset you want to trade or invest in. The greater your knowledge of an asset and its potential pros and cons, the less risk you expose yourself to.

If your portfolio contains a high concentration of one type of asset, your risk levels increase. For example, if you were to risk 25% of your portfolio on an investment or trade and you were to lose twice in a row, you would have lost half of your capital. If you risked just 1–2%, your losses would be much more manageable. For this reason, it is important to diversify your portfolio.

There are many different types of assets you can invest in or trade, and some are riskier than others. For example, crypto and commodities tend to expose investors and traders to more risk than diversified ETFs or fixed-income assets.

Managing risk while Trading or Investing

There is a difference between how traders and investors manage risk, as short-term considerations often differ from long-term ones.

When discussing the difference between trading and investing, a common difference is that traders conduct more transactions over short periods of time, while investors buy and hold assets for the medium or long term. 

Discover some different approaches to risk management when trading or investing below.

Employing a long-term strategy

Taking a long-term view and developing strategies which can ride out short-term dips in value can help you stick with your plan. One of the few certainties of investing is that there will be periods when markets are distressed and portfolios will report losses. Effective risk management involves accepting that in terms of drawdowns occurring the best approach is considering “when” not “if” they will happen.

If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes.

Warren Buffett

Consistency

One technique which mitigates against the risk of a sudden market wide crash is to allocate capital to investments on a regular basis. Consistently drip-feeding cash into your investment portfolio, perhaps on a monthly basis, reduces the risk of a large Day 1 investment being followed by a bear market crash on Day 2.

Diversification

This is perhaps the most important method of risk management. It’s as simple as the saying: “don’t put all of your eggs in one basket.” Any asset can experience a fall in value and building a portfolio made up of a large number of smaller positions reduces the risk of one bad position significantly impacting overall returns.

Hedging

While diversification is about spreading risk across various instruments, hedging is about taking specific measures to protect your investment. Some assets have an inverse relationship to others, meaning that they could be used as safeguards for scenarios in which the main investment goes down in value.

Many traders focus on one asset class, such as currencies. When it comes to the currency market, trades are often hedged by opening positions on gold or other precious metals, as they often have an inverse relationship to fiat currencies. 

Traders may also look for a specific asset that matches their trade for hedging purposes, such as the JPN225 Index, which often moves inversely to the US Dollar/Japanese Yen.

77% of retail CFD accounts lose money.

Stop-Loss and Take Profit

These are automated instructions to trade out of positions and manage exposure to the market when prices reach a certain level. A stop loss order closes out all, or part of, a position and is designed to cut losses on losing trades. A take profit instruction works in a similar manner but is designed to crystalise gains on winning trades.

Since many traders rely on technical analysis, they often have a range in mind within which they believe a certain asset will move. Therefore, they can place Stop-Loss and Take Profit orders at either end of this range to control the risk involved. They will know both their maximum loss and their potential maximum gain.

Self-imposed rules

Designing and applying a series of self-imposed rules can help you stick with your strategy. This reduces the risk of emotions influencing your decision making when markets are distressed or becoming too greedy when results are going your way.

One such example is “The 1% Rule,” where a trader will never allocate more than 1% of their equity to a single trade.

Although risk tolerances vary, it is advisable to risk no more than 2% of your account per trade and, when investing, no more than 5% of your account on an investment.

Final Thoughts

Applying risk management techniques will not only result in your portfolio being designed to manage the unexpected, but will also instil a degree of discipline and professionalism into your overall approach. 

A more considered approach can also reduce the amount of stress experienced by your portfolio, which allows you to stick with your long-term goals rather than panic when market volatility inevitably spikes.

Learn more about investment strategies on the eToro Academy.

Quiz

FAQs

Why is risk management important?

Risk management is important as it allows you to gain an understanding of the risks involved in trading or investing and allows you to apply strategies that may assist in mitigating potential risks.

Do you need a risk management strategy?

Yes, it is a good idea to use risk management techniques when investing and trading. Risk management is imperative to helping you build long-term success and can help you to identify and manage risks you may encounter.

Which risk management strategies should you use?

As individual investors and traders have differing goals and risk tolerances, the right risk management strategy will vary from individual to individual. To find the best fit for you,  consider the types of assets you are investing in, how much you can afford to lose, and the strategies you may already be employing or could potentially use moving forward.