When starting to look into the world of finance, you will most certainly come across the term “risk management.” While the name may sound self-explanatory, there is actually quite a lot to know about risk management, especially when it comes to risking your own money for online trading or investment.
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 trading decisions.
Table of Contents
What is Risk Management in Finance?
As the name suggests, risk management has to do with considering the risks involved with certain transactions, calculating them and taking measures to reduce them. Investopedia defines Risk Management as “the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.” The equivalence between risk management and uncertainty is an important part of understanding how to manage risk, as it is basically the practice of removing as much uncertainty as possible.
This, however, does not mean that risk management is always about reducing risk. Reducing uncertainty is very important, but often traders and investors willingly choose a high-risk investment if they feel the risk/reward ratio will make 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.
How does risk Management Apply to the Stock Market?
The rule of thumb in risk management when investing in stocks is that the greater the risk, the greater the potential reward. Naturally, this isn’t a black and white scenario and there are many moving parts and unknown variables to consider. However, it makes financial sense to categorise risk/reward ratios this way, since it gives investors a spectrum within which to measure risk.
There are various approaches to risk management when investing in stocks. For example, investors may analyse the past performance of a certain asset to determine its potential volatility. Another approach is to diversify investment across several different instruments or asset classes. Investors who buy shares that have the potential for high volatility will often hedge their investment by adding lower-risk stocks to their portfolio, or even identifying assets that have an inverse relationship with the ones in which they are investing. This way, if the main investment goes down in value, some of the equity is protected by the stability and potential increase in the hedging stock.
Managing Risk as an Investor
When discussing the difference between trading and investing, a common differentiation 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 the way traders and investors manage risk, as short-term considerations often differ from long-term ones.
When it comes to long-term investment, here are some keys to use to manage risk effectively:
- Employing a long-term strategy — Warren Buffett once said: “If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes.” 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. Companies aim to have their stocks grow in value and the indices which reflect each market’s health, comprise stocks of top-performing companies. Therefore, when investing for the long term, investors should remember that it is a long-term journey and that temporary drawdowns are completely normal.
- Consistency — Following up on the above points, many investors also regularly add the same amount to their investments in regular intervals. This way, regardless of how the stock performs, a steady influx of equity is maintained, sometimes adding more shares to their positions and sometimes less. However, since companies are geared for long-term growth, this strategy is believed to increase profitability over time, especially when it comes to companies that pay out dividends.
- 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.” 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. If one or two of the stocks 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 marketwide trends, such as bullish rallies or bearish periods. To add even more diversification to your portfolio, you may want to consider investing in instruments that give exposure to a basket of stocks, such as ETFs or eToro CopyPortfolios.
- Hedging — While diversification is about spreading risk across various instruments, hedging is about taking specific measures to protect your investment. As explained above, some assets have an inverse relationship with others, meaning that they could be used as safeguards for scenarios in which the main investment goes down in value. A good example is the VIX index, which is designed to go up when markets become volatile. While there is no direct investment in indices, an investor could allocate some of their funds to invest in ETFs or ETNs that mirror the performance of a certain index.
If you’re looking for a good example of a successful investor who knows a thing or two about risk management, check out eToro Popular Investor @JeppeKirkBonde.
Managing Risk as a Trader
As opposed to an investor’s long-term strategy, a trader focuses more on short-term performance. Due to this different approach, risk management as a trader is quite different to that of an investor. It is often tempting to dismiss risk-management practices altogether when trading, however, it is just as important as when investing — and in some ways even more important. Traders often use leverage and trade extremely volatile assets, which are all the more reason to place an emphasis on risk management.
There are quite a few ways to manage risk in short-term trading. Here are some that are worth noting:
- Stop Loss and Take Profit — These orders are the bread and butter of responsible traders, as they can both 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 when trading, 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.
- Diversification — As explained in the previous section, diversification is always important when dealing with financial markets. Traders will sometimes open and close trades within hours, or sometimes minutes. However, if their strategy is slightly longer term, ranging from days to weeks, they can definitely utilise diversification to spread out their risk.
- Hedging — 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 with 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 Japanese Yen.
- Self-imposed rules — 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.
For a good example of how a trader can both manage risk and generate steady profits, check out eToro Popular Investor @OlivierDanvel.
Dealing with Black swan Events
A Black Swan event is an unpredicted event of extreme significance. The term was coined by mathematical statistician, Naseem Taleb. There are three rules for classifying such an event: Unpredictability, massive impact and providing explanations in hindsight. Such events include the Great Depression of the 1930s, the Great Recession of 2008, and most recently, the 2020 coronavirus pandemic.
By definition, a Black Swan cannot be anticipated. However, it is possible to be prepared for, and deal with such an event in a way that minimises the risks it brings:
- Diversification — Once again, one of the keys to risk management. By maintaining a portfolio that spans different assets, sectors and asset classes, your risk is spread more evenly, and even if an entire market tanks, you still might have some safeguards in place.
- Rebalancing — It is easy to look at long-term investment using a “fire and forget” approach. However, it is important to re-examine and re-evaluate your portfolio periodically. If you manage your portfolio on your own, make sure to check and rebalance it at least once per quarter.
- Copy people — There are many experienced traders and investors out there. On some platforms, such as eToro, you can copy their actions with some of your funds. While it is possible that they will make mistakes, utilising different trading styles and strategies simultaneously could help you navigate the stormy waters of such an event.
- Keep up with the news and numbers — If you’re a “hands on” investor, make sure to read every financial report issued by a company in which you invest and stay up to date on the news and statistics of global markets.
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, try to 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, and even if you choose to go for a high risk trade or investment, do so with your eyes open.
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 having 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.