How Traders and Investors Manage Risk in Stocks
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Learning How to Manage Risk as a Trader or Investor is one of the most important steps you have to take on the path to becoming a sustainably profitable trader or investor.
When you first start investigating the world of finance, you will almost certainly come across the term “risk management.” While the name may seem self-explanatory, there is a lot to learn about risk management, particularly when it comes to risking your own money for online trading or investment.
Every day, risk management takes place. You manage risk when you drive your car and decide whether or not to run a yellow light. You manage risk when you decide whether to eat a healthy lunch or go to the nearest fast food restaurant. However, in finance, the field becomes more specific and calculated, as investment managers, brokers, bankers, and private investors use various measures to estimate the risks associated with their trading decisions.
How to Manage Risk as a Trader or Investor in Stocks
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What is Financial Risk Management?
Risk management, as the name implies, is concerned with assessing the risks associated with specific transactions, calculating them, and taking steps to mitigate them. Risk management is defined by Investopedia as “the process of identifying, analysing, and accepting or mitigating uncertainty in investment decisions.” The equivalence of risk management and uncertainty is an important part of understanding how to manage risk because risk management is essentially the practise of removing as much uncertainty as possible.
This is not to say that risk management is always about lowering risk. While reducing uncertainty is critical, many traders and investors will willingly choose a high-risk investment if they believe the risk/reward ratio will make it worthwhile. This is perhaps the most important concept to grasp when learning about risk management: risk management is not about lowering risk, but rather about knowing as much as possible about the risks associated with a particular transaction.
What is the Role of Risk Management in the Stock Market?
When it comes to risk management when investing in stocks, the rule of thumb is that the greater the risk, the greater the potential reward. Naturally, this is not a black and white situation, with many moving parts and unknown variables to consider. However, categorising risk/reward ratios in this manner makes financial sense because it provides investors with a risk spectrum within which to measure risk.
When it comes to stock investing, there are several approaches to risk management. For example, investors may examine a specific asset’s past performance to determine its potential volatility. Another strategy is to spread your investment across multiple instruments or asset classes. Investors who purchase shares with a high volatility potential will frequently hedge their investment by adding lower-risk stocks to their portfolio or identifying assets that have an inverse relationship with the ones in which they are investing. As a result, if the value of the main investment falls, some of the equity is protected by the stability and potential increase in the hedging stock.
Risk Management as an Investor
A common distinction between trading and investing is that traders conduct more transactions over short periods of time, whereas investors buy and hold assets for the medium or long term. There is a distinction between how traders and investors manage risk, as short-term and long-term considerations frequently differ.
Here are some tips for effectively managing risk in long-term investments:
Using a long-term strategy
As Warren Buffett once said, “If you are not willing to own a stock for ten years, do not even consider owning it for ten minutes.” This is an important concept to keep in mind when investing. While markets experience bearish periods as well as significant drawdowns and crises, markets are designed to constantly rise. Companies want their stocks to increase in value, and the indices that reflect the health of each market include stocks from top-performing companies. As a result, when investing for the long term, investors should keep in mind that it is a long-term journey with temporary drawdowns.
Consistency
Following on from the preceding points, many investors add the same amount to their investments at regular intervals. This way, regardless of how the stock performs, a consistent influx of equity is maintained, sometimes adding more shares to their positions and sometimes less. However, because companies are geared for long-term growth, this strategy is expected to increase profitability over time, particularly for companies that pay out dividends.
Diversification
Diversification is perhaps the most important risk management strategy. It’s as simple as “don’t put all of your eggs in one basket.” Basically, companies can suffer unexpected losses or even bankruptcy, which is why it is best to diversify your investments when constructing a stock-based portfolio. If one or two of the stocks perform poorly, the portfolio has other assets to keep the overall performance afloat. Naturally, the portfolio is still vulnerable to broad market trends such as bullish rallies and bearish periods. To further diversify your portfolio, consider investing in instruments that provide exposure to a basket of stocks, such as ETFs or eToro Smart Portfolios.
Hedging
Whereas diversification involves spreading risk across multiple instruments, hedging involves taking specific steps to protect your investment. As previously stated, some assets have an inverse relationship with others, implying that they could be used as safety nets in the event that the primary investment loses value. The VIX index, for example, is designed to rise when markets become volatile. While there is no direct investment in indices, an investor could invest some of their funds in ETFs or ETNs that track the performance of a specific index.
If you’re looking for a successful investor who understands risk management, look no further than eToro Popular Investor @JeppeKirkBonde.
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Risk Management as a Trader
A trader, as opposed to an investor, is more concerned with short-term performance. Because of this difference in approach, risk management as a trader differs significantly from that of an investor. It is tempting to dismiss risk-management practises entirely when trading, but they are just as important — if not more so — when investing. Traders frequently use leverage and trade extremely volatile assets, which emphasises the importance of risk management.
There are numerous methods for managing risk in short-term trading. Here are a few that are noteworthy:
Stop Loss and Take Profit
These orders are essential for responsible traders because they can both protect against loss and lock in profit. A Stop Loss order, as the name implies, closes a trade when a certain loss is reached. When a certain profit point is reached, Take Profit does the same. Because many traders rely on technical analysis, they frequently have a range in mind within which they believe a particular asset will move. As a result, they can control the risk by placing Stop Loss and Take Profit orders at either end of this range. They will be aware of their maximum loss as well as their potential maximum gain.
Diversification
Diversification is always important when dealing with financial markets, as explained in the previous section. Traders will occasionally open and close trades within hours, or even minutes. However, if their strategy is slightly longer term, ranging from days to weeks, diversification can definitely be used to spread out their risk.
Hedging
Many traders concentrate their efforts on a single asset class, such as currencies. In the currency market, trades are frequently hedged by opening positions in gold or other precious metals, which frequently have an inverse relationship with fiat currencies. Traders may also seek a specific asset that corresponds to their trade for hedging purposes, such as the JPN225 index, which moves inversely to the Japanese Yen.
Self-imposed Rules
Traders look for large price swings to exploit and frequently use leverage. This may tempt them to allocate a large portion of their funds to a potential trade, putting them at risk of losing a large sum of money. As a result, some traders strictly adhere to self-imposed rules. A well-known example is “The 1% Rule,” which states that a trader should never allocate more than 1% of their equity to a single trade.
Check out eToro Popular Investor @OlivierDanvel for a great example of how a trader can manage risk while also generating consistent profits.
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Managing Black Swan Events
A Black Swan event is an unexpected and extremely significant event. Naseem Taleb, a mathematical statistician, coined the term. Unpredictability, massive impact, and providing explanations in retrospect are the three rules for classifying such an event. The Great Depression of the 1930s, the Great Recession of 2008, and, most recently, the 2020 coronavirus pandemic are examples of such events.
A Black Swan, by definition, cannot be predicted. However, such an event can be prepared for and dealt with in a way that minimises the risks it brings:
Diversification
Diversification is, once again, a key component of risk management. Maintaining a portfolio that spans various assets, sectors, and asset classes spreads your risk more evenly, and even if an entire market tanked, you may still have some safeguards in place.
Rebalancing
It is all too easy to approach long-term investment with a “fire and forget” mentality. However, it is critical to re-examine and re-evaluate your portfolio on a regular basis. If you manage your own portfolio, make it a habit to check and rebalance it at least once a quarter.
CopyTrade
There are a lot of experienced traders and investors out there. You can copy their actions with some of your funds on some platforms, such as eToro. While it is possible that they will make mistakes, using multiple trading styles and strategies at the same time may help you navigate the turbulent waters of such an event.
Keep Up With the News and Numbers
If you’re a “hands on” investor, read every financial report issued by a company in which you invest and stay current on global market news and statistics.
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Control your Risks
It may be tempting to fall for get-rich-quick schemes or online platforms that promise instant profits. However, online trading and investing require time, practise, and, of course, risk management. Consider the information above before making your next investment or trade. Perhaps you are already using some or all of the practises mentioned, or perhaps you are not. In any case, keep in mind that you should always be aware of all of the risks associated with a particular transaction, and even if you choose to engage in a high-risk trade or investment, do so with your eyes wide open.
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Risk Disclaimer: Please remember that 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.
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