Risk Management
Depending on your style of investing, you are going to have different tools for risk management. There are certain tools applicable to all market players, but there are also many specific to both investors and traders. I’ll try to touch on all these, but let’s first tackle the broader more universal tools for managing risk and then move into the investor- and trader-specific ones.
GENRAL RISK MANAGEMENT TOOLS:
1. Maximum Account Drawdown
No matter your style or investment goals, unless your goal is to lose money, you are going to want to establish some boundaries for how much money you are willing to risk for each investment and overall. How much you risk will be up to you and your personal risk tolerance, but if, for example, you have $5,000 in your trading or investment account, you should establish a dollar amount at which you will exit all your positions because you do not wish to lose any more beyond that. If that number is $4,000, you should be very cautious if/when your account drops near that level and prepare yourself for any quick exits to guarantee no amount of money below that mark is lost. Never underestimate how much further markets can fall so stay true to your line in the sand. It can be helpful to commit to an account percentage that you refuse to lose in total or even just in a month (like 20% of the original account value), but there is no one size fits all and you will have to decide that percentage for yourself. My only advice is that you do decide it. Real risk if what you don’t plan for and if you don’t have a failsafe in place to protect you against uncertainty, you could see your account draw down a lot more than 20% or whatever your total account stop-loss is. If that level is ever triggered, exit completely and take some time to reassess your strategy and the market before jumping back in. Don’t blow up your account by fighting the market.
2. Stop-Losses and Maximum Position Drawdowns
In addition to protecting your total account value, you should commit yourself to protecting each specific trade or investment with its own individual stop-loss. Going into each trade, you must have a point at which you accept defeat and pull your money out to prevent any further losses. A general rule of thumb is not to risk any more than 1-2% of your total account size on a single trade, but that number is obviously up to you to decide. You can also have a basic rule of a 5% or 10% stop for your position, but I would still take note of what that is in relation to your account value. Regardless, the point is no single trade should ever wreck your account or negate all the winning trades you had prior to it. Once you enter a trade, calculate the 2% (or whatever number you choose) and add your stop-loss. It’s a safety net when you’re not at the screen and it’s also a safety net when you are. You never know what the future holds and you may not always be able to act quickly or objectively when things go south, so let your stop-loss manage your risk for you. You’ll rest easier knowing you have a tolerable maximum amount you can lose on any given trade.
3. Price Targets and When to Take Some off the Table
Part of managing your risk includes protecting money you’ve made. If your goal is to keep making money and consistently grow your account, you shouldn’t be so willing to let your gains slip away. Price targets can be a great way to force yourself to realize some gains and can be just as important as stop-losses. Any trade that makes you money is a good trade and there is absolutely no shame in closing a position as a winner. It’s often said that making money in the market is easy, but keeping that money is what’s hard. By realizing gains and protecting yourself from any retracements, you are taking steps to keep the money that you make. Now, if you are an ardent buy and hold investor, this may not be for you, but selling when a company is overvalued and rebuying when it’s not is hard to argue with. It’s not always clear when a company is overvalued, but if you are up a significant amount on your investment, feel free to take a small victory lap by realizing a large percentage of your total position. You could also do a smaller percentage, but just don’ be afraid to pay yourself whenever a trade moves in your direction. Another approach both investors and traders often like to take is to remove their original position. If you put $1,000 in and that $1,000 has grown to $1,500, take your initial investment out and let the remainder ride—you’re playing with the house’s money, as it were. Whenever you enter a trade, always keep in the back of your mind a level of profit you would be satisfied with. You can imagine a trade or investment much like a job—how much do you want to get paid for this trade? Is a 10% return enough? 20%? The market is constantly fluctuating and 20% in gains can quickly turn to 5% in losses, so don’t get greedy and manage your risk by adhering to price targets or periodically taking profits as you make money. It doesn’t have to be a lot, just be open to paying yourself.
4. Protecting Your Profits
Risk isn’t just about protecting what you have, it’s about protecting what you make. Just because you’ve made a considerable amount of money from an investment or trade doesn’t mean you should be more willing to sacrifice it. Act as if what you made is what you started with and use your stop-losses to protect gains as they develop. This is a great alternative to price targets if you like to let your winners ride because it still guarantees you some profit if the direction quickly shifts. You don’t want to get in a habit of over managing your trades, but consider trailing your stop every 5% or after some dollar value in gain. Just be careful not to stop yourself out during normal volatility by trailing your stop too closely. A good practice is to only move your stop after a sizable gain or after 1R for the traders out there. 1R would be what you risked for that trade or the distance from your entry to your stop-loss. If you risked $1,000 in a $10,000 trade and you’re now up $1,000, move your stop-loss to breakeven. If price continues higher and you’re now up $2,000, move your stop to secure that initial $1,000 in profits. The idea is to give your position some breathing room while still reducing the risk of excessive drawdowns that could wipe away all your gains. Protect what you make and know that if price retraces and you’re stopped out, you can always get right back in at a lower price. This could stir some concerns over taxes and thus might not be ideal for everyone, but protecting yourself from any drawdown over 15% would negate any tax advantages of holding so don’t easily dismiss securing what you’ve made by incrementally raising your stop if you’re up big on a trade.
INVESTOR RISK MANAGEMENT:
1. Dollar Cost Averaging
The simplest and probably most widely used risk management tool is dollar cost averaging. For whatever reason, investors generally like to enter their whole position all at once. It’s hard to say why exactly we prefer to do this—maybe it’s more exciting or we’re worried our brilliant investment idea is gonna be realized by other market participants any second—but it usually turns out to be a sad attempt at timing the market. Nobody knows what the market is going to do today or tomorrow and that’s fine. While it’s possible whatever you’re trying to invest in could take off tomorrow, it’s very unlikely and you will almost certainly periodically see lower prices in the coming weeks or months. Even if price continues a slow grind up, you would be wise to protect yourself from the volatility and unpredictability inherent to the markets. Take the stress and thought out of timing your investments by committing to a small percentage of your total position size each day or week. If you want to put $10,000 in AAPL, buy $500 every Monday for 20 weeks instead. In doing this, you will all but guarantee you get a reasonable average price and you don’t run the risk of putting yourself in a hole by investing too much at the wrong time. By definition, long-term investments are for the long term so why not take your time building those positions. It may seem too easy to be effective—after all, even a blind monkey could set up a dollar cost average—but this strategy beats just about every investor who isn’t a seasoned pro, and even the seasoned pros use dollar cost averaging as a strategy.
When you come up with an investment idea that excites you, it’s only natural to want to act on it, but making such rash decisions, especially with large sums of money, is very risky and won’t be conducive to longterm success in the market. But rather than fight your idea or desire to own some company’s stock, buy a very small amount then and there and just keep doing that every week until you reach your full position. By putting a little on the table, you will avoid feeling entirely left out if price moves higher, and, if price moves lower, you won’t feel nearly as bad knowing you aren’t losing that much money. And, you’ll now have a great opportunity to lower your average price the next week when you buy again. Dollar cost averaging may take some of the fun out of investing, but investing is about managing your risk and making money, not having the most fun. If you want to gamble, that’s your prerogative, but acknowledge you are likely not going to time the market perfectly and you’d be best served and experience the least amount of stress by simply buying a small amount at a time for an extended period. Don’t be impulsive, manage your risk with time.
2. Diversification and Correlation
Diversification is widely recognized as a useful tool for protecting your wealth and even widely practiced by most investors these days, but it’s rarely executed well. Buying several different assets or companies can cast the illusion of diversifying your portfolio, but this is only the case if what you are buying isn’t all that correlated to what you already own and if your position sizes are properly weighted. Just because you own ten different stocks or multiple ETFs doesn’t mean you’re protected against a serious market drawdown, and even if you are well diversified, if your positions sizes are poorly weighted, that diversification won’t really help you much. In fact, it could mean you’re in a way riskier situation. If you really want to protect yourself from aggressive swings in the market, you’ll want to evenly or strategically spread your exposure across assets that perform differently. Whether they’re completely uncorrelated or just different enough to avoid holding things different in name only, you’ll want to make an effort to mange your risk through true diversity. The illusion of diversity in your portfolio is what’s often referred to as diworsification, which would be something like owning a dozen stocks that essentially move in the same direction or owning strongly uncorrelated assets but having most of your portfolio in just one or two of them. In either case, you might as well put all your money in just one stock. We don’t generally view owning a dozen companies as on par with severe concentration, but if all those assets are strongly correlated or most of your money is in a small handful, that’s pretty much what you’re doing.
Identifying correlations may be difficult if you aren’t familiar with charts and how to overlay different assets to easily visualize the extent to which they’re correlated, but correlations are also pretty intuitive. Companies in a similar or the same sector may vary a little in their performance according to their specific business, but they will usually trend together in the medium to long term. If you’re planning to buy something, first ask yourself what sector or asset class it falls in, what assets you think perform similarly, and if you own anything similar to it already. Investors have a tendency to gravitate towards certain sectors more than others because, for example, they may have a passion for green energy or think AI is the future and it’s fine to have those preferences, but it can quickly lead to overexposure to niche areas of the market. Those sectors may perform very well at times or even in the longterm, but your whole portfolio will essentially live and die with that one narrow section of the market. For this reason, limiting your exposure to a particular sector or asset class to just 10-20% of your entire portfolio is strongly recommended. As always, the exact percentage is up to you to decide, but having some rule about how much you are willing to bet on one kind of business or asset is vital to managing volatility and risk. Concentration can be a better way to achieve aggressive growth, but it’s not easy to do well without a high level of expertise and is also a better way to lose money.
If you want to go beyond mere sector correlations to diversify, you can also account for things like volatility and dividends. On the volatility front, only committing 30% of your portfolio to be invested in stocks more volatile than the S&P500 can reduce much of the ups and downs of your portfolio if that concerns you. And always having a number of dividend-paying stocks can ensure some amount of money is always flowing in no matter what is happening in the market. Both these are great ways to expand the levels to your diversification if correlations aren’t enough for you, but if investing isn’t your passion or day job, this could sound a bit overwhelming, so just know it’s not necessary to diversify. It’s a good next step if you’re looking for ways to hyper manage your portfolio, but if all you need is a simple way to maintain your wealth with slight to moderate growth, regular diversification will be just fine. To accomplish this with relative easy, you can try to find some model portfolios online to map out your allocations or just get ideas of what sectors and assets well-diversified portfolios tend to include. Many model portfolios will even account for things like volatility and dividends so they can be perfect templates to mix and match your desired assets into.
3. Hedging Your Investments
While the average investor tends to be long only, seasoned investors will stress the importance of hedging your largest positions at least periodically. This isn’t alway easy to do if you aren’t familiar with short selling or options, but there are a lot of inverse ETFs that can make hedging incredibly simple. Another important thing to note is you don’t have to hold hedges at all times, but if you’re heavily invested in one stock or sector and want a little bit of a safety net or suspect a shift in the market is coming, adding a hedge can significantly reduce your risk for that period of uncertainty. Hedging may suggest you lack conviction in your investments, but think of it more as an insurance policy. No matter how good your investments are, they won’t be up every day or week and it’s nice to know you’ll have something performing well if and when things go south. Whenever you sense volatility or uncertainty in the market, seek out a hedge and then as soon as sentiment changes or you feel more comfortable, you can sell it. If things trade sideways, no harm, no foul. If things go up, you pay a little bit for that safety net, but you still make money with the investment you’re hedging. And if the market tanks, you’re sure glad those losses are at least somewhat mitigated by that insurance policy you just bought. Now it’s probably not best to always be hedged because you might as well just lower your position size on whatever you’re hedging, but it’s an excellent way to protect your investments without realizing them. Dealing with capital gains can be frustrating, especially if you’re trying to hold out for that one year mark to lower your tax rate, but you also don’t want to lose any of your unrealized gains. Rather than roll the dice or suffer through the headache of realizing too early, just buy a hedge and sleep easy knowing you’re protected.
4. Spread Trades
This tool will probably only be for very experienced investors because it incorporates short selling, but it’s an amazing way to reduce risk in the market. The idea is to go long one asset and go short another very similar asset with an equal weighting. In doing so, you are capturing the spread between those two assets. For example, if you went long MSFT for $10,000 and short AAPL for $10,000, you are just hoping MSFT slightly outperforms AAPL in the future. Both assets can perform very well or very poorly and you make money so long as MSFT just does a little better. This strategy considerably limits both downside and upside risk because of how correlated the assets are. MSFT and AAPL are both large tech companies that mirror each other quite nicely in the medium and long term, so when the market is up, they are probably both up, and when the market is down, they are probably both down. You just want MSFT to be up a little more and down a little less in the longterm. Note this trade can really be applied to any two assets, but it’s best to apply to similar ones like Gold and Silver, Walmart and Amazon, Moderna and Pfizer, and the list goes on. All you’re doing is trying to identify an out-performer in a sector to buy and then shorting a competitor to reduce your risk. Once you figure out an effective way to long and short whatever assets you choose, it’s an incredibly easy trade to manage and usually not super stressful so long as the two assets really are similar. You can attempt this on more dissimilar assets to capture larger spreads, but larger spreads also mean more risk so think long and hard about what the appropriate spread trade would be for you and your risk tolerance.
TRADER RISK MANAGEMENT:
- Position Sizing
Though position sizing is important for investors, I’d say it falls more within the realm of proper diversification. Investors can and should size their positions based on their conviction, but this is much more important as a trader when you’re chasing quick gains and more in tune with probabilities, so I think it makes more sense to include it in this section.
Your position size is one of your greatest tools in the market. No trade is identical and so it would follow your position size should reflect that. All trades have different probabilities and, regardless of your strategy, there are gong to be better and worse setups. Your conviction when taking a trade should really be proportionate to the money you’re putting in. Low confidence should mean a small position and high confidence should be a sizable position. It’s all about finding an edge in the market and risking less on what you believe are riskier setups or risking more on what you believe are great setups could be all that you need to catch that edge. Risking the same amount of money on each trade is akin to saying the potential profitability of each trade is the same. But that is, of course, not the case. Certain setups of yours could have higher win rates than others and betting more money on those higher probability trades could dramatically increase your profitability. Bet big when you have a good hand and bet conservatively when you don’t.
Another way to use your position size to manage your risk is by raising it when the market is on your side and lowering it when the market is against you. Hot streaks and losing streaks are very common in trading. Sometimes you’re in the zone and other times you’re not and the market is very unforgiving. Rather than trade away your account or whatever gains you may have, manage your risk through your position size. Whenever you have back-to-back losses, it’s possible you’re a little off or the market just isn’t giving you what you need for your strategy to work, so reduce the amount you’re risking. Markets are constantly shifting and it’s possible your strategy has very on-again/off-again moments under certain market conditions. If it seems like your wins and losses frequently come in waves, then having a rule in place to protect you from red days or bank even harder on green days could be the difference you need to stay or become profitable. If your normal position size is $500 and you’ve had back-to-back losses, cut it to $400. And if you lose again, cut it to $300. Don’t fight the market when it’s fighting you—just limit your exposure until you feel like the tides are shifting again. I’ll suggest extending this logic to your wins as well, but progressively increasing your position size after consecutive wins is a good way to lose all your gains after that big one finally loses. That said, you should consider implementing larger positions if and when you’re in a cycle or period where your strategy yields better results. Just make sure not to get carried away. Bigger returns when you win and smaller losses when you lose seems like a pretty simple concept, but don’t let it be too subjective. The goal is to reduce your risk by carefully calculating the probability of success for each trade. Arbitrarily changing your position size can have the exact opposite effect and actually increase your risk. Try to be rules-based even if it just has to do with consecutive losses and focus on perceived or statistically-backed win rates to strategically size your positions.
2. Daily Drawdowns and Goals
While this also could technically apply to investors, it’s far more applicable to traders. Long-term oriented investors shouldn’t concern themselves too much with day-to-day price action, but your daily PnL is extremely relevant if you’re a day trader. Though red days are expected, I would recommended having a hard cap on what you can lose each day—once you reach that level, stop trading and go do something else. It’s easy to have an off day in trading that leads to cascading losses and ensuring you’ll never lose more than, say, 5% of your total account, will save you from those occasional excessive losing days that can set you back a whole week or even month.
This mentality can prove equally effective with daily profit targets as well. There’s nothing worse than making a bunch of money and giving it right back because you kept trading. If you set a goal for yourself of $100 or $500 dollars a day, feel free to stop trading if and when that goal is reached. Part of managing risk is setting attainable goals that keep you from succumbing to greed or overtrading. Establish a reasonable amount you want to make each month and break that down into a daily goal. You don’t have to be religious about reaching it every day or even stopping when you do reach it, but it will keep you trading more practically like you really are there just to earn a paycheck. Don’t bank on that one day where you make $10k, strive for consistency and have a general idea of what you want to shoot for each day. You can increase that daily target as your account grows, but big goals start with little ones and you have to keep it simple if you want a consistent progression. Having loose goals or one massive goal of making $100k can lead you to risk more than you should and just overlook all the stepping stones needed to reach any pie in the sky number like that. Rome wasn’t built in a day—you have to take each day in stride and focus on every house, road, little business, and everything else that eventually leads to the whole city. Small daily goals add up over time so strive to keep your trading and profits in a practical and sustainable range.
3. Statistics and Expected Return
Statistics won’t be available to you in any meaningful way until you have a good amount of trades to draw from, but they will be very useful to calculate once you do. There are a million different stats you can track, but one of the most important ones is your expected return for each trade or expectancy. You can measure this in dollar amount, but doing it in percentage points is more accurate if your position sizes vary. By taking your win rate and multiplying it by your average win percentage and then adding that to your loss rate multiplied by your average loss percentage, you will get your expected percentage return for each trade. This is a useful tool for risk because it tells you where you should consider exiting your trades and potentially what trades or markets work best for you. If your expectancy is 15%, that can represent a good place to take profits. And if you calculate your expected return for all your different strategies or assets you trade, you can start to hone in on the best setups and markets. If your expected return for a particular asset or strategy is less than your total expected return, you should consider abandoning it as it could be holding down your profitability. Lower expected returns means you should be risking less. You want to risk the most on your trades that having the least risk or the highest chance of success, which you can only really find out through statistics.
Trading journals are a great way to keep track of your stats or even automatically calculate things like expected return for you, but you can also write it all down yourself and do the math every once in a while to gauge your results as they develop. However you try to track these things, just understand how helpful it can be. Statistics don’t lie and eventually, as the data set grows, they will reliably guide you toward the trades with the highest probability of success and drive you away from the trades that lose you the most money. Don’t be lazy and try to internalize your stats because it’s impossible to do that with the precision you should want. Having cold hard numbers to back your trades will help you take your trading to the next level. The more information about your trades you can get, the better, and having a mountain of statistically-backed numbers to point you in the right direction will help you more effectively map your price targets and focus your time and money on the trades that work. Math doesn’t lie so let the numbers manage your risk for you.
Conclusion
Throughout your trading or investing career you will almost certainly develop more rules for managing your risk than I’ve mentioned as so much of trading the markets revolves around our unique strategies. Try to use these rules I’ve discussed if and when they are applicable to you, but also look to incorporates new tools as you make mistakes or see potential for improvement. Honing in on your risk and meticulously tracking exactly how much you can and are willing to lose is essential to achieving consistent results and longevity. Those who fail to manage their risk will likely fail to make money in the long run. Make rules around your risk and never let the market take more than you’re willing to give.
Now, before I sign off, I want to leave you with a couple quotes that are somewhat at odds with each other, but they encapsulate both ways market participants should perceive risk. The first quote is a note of caution by Warren Buffett to remind investors what the real goal is: “Rule number one: Never lose money. Rule number two: Never forget rule number one.” Most people enter the market to make money without giving much thought to how easy it is to lose money. Never lose sight of the risks and try just as hard not to lose money as you do to make it. The last quote I’ll leave you with is by William Faulkner and will remind you risk is inherent to discovery and success, so don’t be afraid to embrace it if you want to succeed. “You cannot swim for new horizons until you have courage to lose sight of the shore.”