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.
Risk management happens every day. When you drive your car and decide whether or not to run a yellow light, you’re managing risk. When you choose whether to eat a healthy lunch or go to the nearest fast food place, you’re managing risk.
However, in the realm of finance, the field becomes more specific and calculated as investment managers, brokers, bankers and private investors employ various measures to estimate the risks involved with their investment and trading decisions.
What is risk management?
Risk Management Strategies for Smart Investing/Trading.
As the name suggests, risk management has to do with considering the risks involved with certain transactions, calculating them and taking measures to manage them.
“Risk comes from not knowing what you are doing”Warren Buffett
The equivalence between risk management and uncertainty is an important part of understanding how to manage risk, as it is basically the practice of keeping a good risk/reward ratio. But often, traders and investors will willingly choose a high-risk investment if they feel the risk/reward ratio makes it worthwhile.
This is perhaps the most important thing to understand when learning about risk management: it is not about lowering risk, but about knowing as much as possible about the risks involved with a certain transaction.
There are three key factors that influence risk:
- 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
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. There is a difference between how traders and investors manage risk, as short-term considerations often differ from long-term ones.
Discover some different approaches to risk management when trading or investing below.
Employing a long-term strategy
If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutesWarren Buffett
This is an important notion to consider when investing. While there are bearish periods in markets and significant drawdowns and crises, markets are designed to constantly go up. When investing for the long term, investors should remember that it is a long-term journey and that temporary drawdowns are normal.
Following up on the comments above, many investors also regularly add the same amount to their investments at regular intervals. This way, regardless of how the asset performs, a steady influx of equity is maintained, sometimes adding more to their positions and sometimes less.
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.” Basically, sometimes companies experience unexpected drawdowns, or even bankruptcy, which is why it is advisable to invest in several different companies when building a stock-based portfolio, as well as various other assets.
If one or two of the assets take a turn for the worse, there are other assets in the portfolio to keep the overall performance afloat. Naturally, the portfolio is still exposed to market-wide trends, such as bullish rallies or bear markets.
This risk management strategy is often adopted by investors and traders alike.
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.
77% of retail CFD accounts lose money.
Stop-Loss and Take Profit
These orders are the bread and butter of responsible traders, as they can protect from loss and lock in profit. As the name suggests, a Stop-Loss order closes a trade once a certain loss is reached. Take Profit does the same when a certain profit point is reached.
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.
Traders look for big price swings to take advantage of and often use leverage. This may tempt them to allocate a large chunk of their funds to a potential trade, which also puts them at risk of losing a lot of money. Therefore, some traders religiously follow self-imposed rules.
A prominent example is “The 1% Rule,” according to which a trader will never allocate more than 1% of their equity for 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.
Manage your risks
It may be tempting to succumb to promises of get-rich-quick schemes or online platforms that offer instant profits. However, in reality, online trading and investing take time, practice, and of course — risk management.
Before making your next investment or trade, consider the information above. Maybe you are already employing some or all of the practices mentioned, and maybe you’re not. Either way, remember that you should always familiarise yourself with all of the risks involved with a certain transaction.
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- 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 strategies 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 for your circumstances will vary. 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.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.