Risk management in stock is a topic that deserves more attenion than it already has. It is, as a matter of fact, one of my favorite topic, however, it is not a common topic that is being discussed. Afterall, isn't it much better to look at the brighter side of things?
“People should be more concerned with the return of their principal than the return on their principal.”
~ Will Rogers
Go and pick up any trading related book that is worth its salt, you will quickly notice that Risk Management is one common thread running through these books. So, what exactly is Risk Management when it comes to trading and / or investing?
Before we go head on to discuss the various aspect of Risk Management, it is imperative that we cover the topic of Risk Appetite. Risk appetite is a essentially the acceptable level of risk that an individual willing to take towards achieving his / her investment objectives. i.e. The willingness to accept certain level of risk in order to achieve one's investment goal.
There are a few ways to manage risk, including a. Recognizing the risk b. Avoid the risk, c. Scaling down / manage the potential negative effect of the risk and lastly d. Acceptance of the risk.
- Recognizing of Risk
"There are three kinds of men. The one that learns by reading. The few who learn by observation. The rest of them have to pee on the electric fence for themselves."
~ Will Rogers
It is rather obvious that, before a risk can be avoided or minimize, it has first to be recognized. Let us then, try to list out the potental areas of risk when comes to the investment of common stock:
a. Concentration of position.
b. Trading / Investing of Penny stocks.
c. Buying stocks at an expensive price.
d. Newly listed stocks.
- Avoid the Risk
"The market does not know you exist. You can do nothing to influence it. You can only control your behavior."
~ Alexander Elder
After recognizing the risk, the obvious and next natural step will be to avoid the risk. This can then be done through (in contrast with the list above).
a. Some form of Diversification.
b. Trading / Investing of Blue chips or REITs
c. Buying with margin of safety i.e. Value investing
d. Stocks with reliable track records.
- Scaling Down / Managing Risk
Here's one of my favorite quote, from Ed Seykota (who pioneered Systems Trading. In the influential best seller, Market Wizards, author Jack D. Schwager devotes a chapter to Ed and mentioned that his "achievements must certainly rank him as one of the best traders of our time.”)
“The trading rules I live by are: (1) Cut losses. (2) Ride winners. (3) Keep bets small. (4) Follow the rules without question. (5) Know when to break the rules.”
~ Ed Seykota
For the purpose of our discussion here, I would like to bring your attention to point 3 and 4. i.e. Keeping bets small and follow one's trading rules (another topic on its own altogether) without questions.
Let me again introduce you to the Pie chart above, which I first mentioned in an earlier article, on the topic of "Trading Psychology: How you can Improve Your Trading Results".
From the above, it could be seen that Money Management formed an integra part of the trading process.
Let us first begin with Capital Management. Capital managment is basically the % of your total capital that you are willing to put at risk for any single trade or investment.
A common percentage being used is 2% (or less) of total investable capital. It is, however, also to tie in with one's psychological threshold. Meaning, if your pain level for each trade is $500 dollars, but your Capital Management suggest a $800 stop loss, it is better for you to reduce your investment / trade size, so that if you need to carry out a cut loss, it is mentally tolerable to you. For some people, a protection of emotion could mean more than protection of money.
The next important aspect to tie in with Capital Management is Position Sizing, which essentially answers the question: “How much am I willing to lose in any single one trade?”
Position sizing should form an integral part of your trading system as it tells you how large should your trade size be, by having the right position sizing, one could minimize the chance of a large potential draw down.
With the above, I shall conclude this article for now. I look forward to elaborate on the details of Position Sizing, which involve setting the % of each position one is willing to risk either using a set % (usually 7-8%) and / or depends on, for example, the Support Level of a chart.