Stock market risk management is one of the most challenging skills for an investor to master. Investing in the stock market is fraught with worry for a good reason. If you lose half of your investment, you must double your return to just breakeven. Warren Buffett, considered by many to be the world’s greatest investor, states his first rule of investing is “do not lose money.” Unfortunately, the risk in the stock market of losing your money is always a possibility. However, without taking some risk, there is no reward. Therefore, successful investors employ stock market risk management strategies to minimize their losses. Managing risk in the stock market starts with identifying the type of risk and taking action to mitigate the impact of the risk on your investment portfolio.
Risk in the stock market comes in many forms, and each can lead to a loss. The most common is the overall trend of the market. Approximately 60 % of the move of an individual stock is attributed to the stock market trend. If the stock market is rising, it takes with it most of the other stocks, though not in equal amounts. When the stock market falls, stocks sink with it. Part of managing stock market risk is being on the right side of the trend.
Another big risk in the stock market lies with owning an individual stock. While owning a company’s stock can offer greater rewards, it also entails the risk that something might go wrong that can cut the price of the company’s shares in half. It might be news that sales have suddenly fallen due to a new competitor or a product liability issue has arisen. For whatever reason, individual stocks are subject to risk associated with them alone. Diversifying your holdings is one of the best ways to address the risk associated with holding individual stocks.
While there are other risks in the stock market, these encompass the vast majority of the ones you will encounter. Fortunately, investors can employ several strategies as a part of their stock market risk management program.
First, they can invest in the trend of the market. Following the trend is a proven method to help manage the stock market’s risk, though it is not as easy as it sounds. Trend following tries to identify and then align with the underlying trend of the market. The assumption is the market will be in a trend that could last a day, a week, a month, a year, or multiple years. Generally, short-term trends cycle within longer-term trends. Depending on your time frame, you can align your stock position with the trend once you have identified it. When you follow the trend, you are able to reduce the likelihood your stock will fall when the market trend is rising.
Another proven risk management strategy for owning stocks is to diversify your portfolio across several different companies, sectors, and asset classes. By owning several different stocks, you reduce the impact of a loss in any one company. Moreover, if the stocks you own are from several different industry sectors, you mitigate the impact of any one sector causing a loss.
Exchange-Traded Funds (ETFs) offer an excellent way to add diversity to your portfolio, as they hold shares of companies based on an index. The index can be for the whole market or any segment of the market. When using ETFs, be sure there is sufficient liquidity (plenty of shares trading), or you will create another unwanted risk.
Many investors size their stock position based on their tolerance for risk. Dr. Van K. Tharp performed an experiment on position sizing in his book Trade Your Way to Financial Freedom.
Successful investors employ stock market risk management strategies to minimize their losses. Managing risk in the stock market starts with identifying the type of risk and taking action to mitigate the impact of the risk on your investment portfolio. As Dr, Tharp found adjusting your stock position’s size using percent risk or volatility significantly increases your returns. By adjusting your position’s size based on the risk you are willing to assume, you lower your potential of a loss and increase your probability of solid gains. Our article on Position Sizing provides further detail on this method to manage stock ownership risk.
Should your stock price turn down, wouldn’t it be nice if you could exit your position before the price fell further. Stop-loss or trailing stops are tools used by many investors to close their position should the price fall by a specified amount. Most brokerage firms allow the use of stops using a set number of points below the price or a percent below the price. Trailing stops follow the price up by an amount you set and then hold that price level on any move down. The idea of this stock market risk management technique is to leave enough room for the stock price to fluctuate within its uptrend but be ready to sell should it fall below a pre-determined level. Some investors use mental stops as a part of the stock market risk management process. Mental stops work well as long as they have the self-discipline to sell when their stop price is hit.
Many people believe equity options are risky investments. It is true that options can be risky as they increase your use of leverage. However, professional investors use specific options to reduce the risk of their portfolios. Covered call options are an excellent way to create some downside protection while increasing your portfolio’s potential return. Covered calls are suitable for IRA accounts, indicating that the authorities consider them a low-risk investment strategy. Protective put options are another method to lower the risk of a portfolio. Similar to insurance, protective puts provide security should your long positions suddenly fall in price. When that happens, the put option guarantees you will receive the agreed-upon price for your stock no matter how far it falls. You can learn more by reading articles on covered calls and protective puts that describe the features and benefits of these stock market risk management strategies.
The goal of any stock market risk management process is to avoid losing money. Fortunately, there are several strategies to help you to achieve this important goal. The most successful investors employ all the stock market risk management strategies, as they recognize how important it is to avoid making a mistake while investing in the stock market. Do your portfolio a favour and use the available stock market risk management techniques to your advantage.
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