How To Do Proper Risk Management For Your Investment
Investing is all about taking a calculated gamble with the hope of achieving high returns and low losses. However, there are times when investors make decisions that they might later regret because some of them can potentially lead to huge loss of capital or even bankruptcy, if not handled carefully.
The best way for an investor to avoid such situations is by following proper risk management procedures before making any decision on their investments. Risk management plays a vital role in every aspect of life including business, finance and sports. It also helps people maintain control over their finances during uncertain economic conditions. So how exactly do we apply proper risk management to our investments? I explain below:
Identifying The Risks Before You Invest
Before you can make wise choices in your investments, you need to be aware of various macroeconomics factors which could affect your financial future. These include things like interest rates prevailing at different time periods and exchange rate. You must have heard these terms many times but do you really know how they work and why they matter so much?
Let us first discuss “Interest Rates” – Interest Rates play a major part in shaping the market values. Interest rates are basically what people often define as the most defining macroeconomics factor. If you are a borrower, the interest rate is equal to the amount of fee you are charged for borrowing money. Interest rate also affects how much interest you will be getting if you save your money in the bank.
It’s particularly smart to invest in crypto or stock or even forex when the interest rate gets slashed by the central bank (especially when it comes to the USD price action and the Fed’s policies around it), since it has hugely affected the bull and bear market cycles as we have seen this year.
And that brings us to the next topic ‘Exchange Rate’. Exchange Rates determine the purchasing power of currencies against other national currencies. When foreign countries’ economies grow stronger than ours, their currency becomes relatively cheaper and vice versa. One good indicator of the rising strength of the economy abroad is measured through GDPIndex. A country’s GDP refers to Gross Domestic Product which measures total output produced within a given period.
To calculate GDP, economists add up gross domestic product generated last year plus 1 minus change in inventory valuation to arrive at the final figure. Generally speaking, higher values indicate better performances.
It’s important to see both the exchange and interest rates before you decide to get in, since they identify the trend patterns much better than any technical analysis.
Why it is important to manage your risk in investment
Now that you have understood the working mechanism behind Interest Rates and Exchange Rates, let’s put it into perspective regarding your portfolio.
Here comes another term called RRR. It stands for Rolling Returns Ratio and indicates the average returns achieved compared to the benchmark index used to measure those returns. For example, if S&P 500 had returned 7% whereas your fund earned 6%, you would qualify as an underperformer.
On the contrary, if your fund outperformed the benchmarks, you would be considered a Super Performer.
Finally, the most common term related to risk management is Drawdown. It simply highlights the gap between the highest and lowest amount of balance in your trading account, obtained in a certain trading period. So, if the drawdowns of your funds were consistently above 30%, you should consider changing your strategy.
According to research studies, more than 90% of mutual funds fail to beat the relevant benchmarks over the long run.
Furthermore, data shows that less experienced traders who trade less often perform worse than professional traders. Also, the study found that novice traders incur greater losses due to lack of experience and bad risk management rather than bad strategies. All these findings support the fact that amateurs may have good trading strategies but they are useless if there’s no proper risk management.
So, how can you protect yourself from losing big bucks? Well here again comes the importance of risk management. By managing your risks correctly, you can minimize potential losses and maximize gains. There are several ways to go about doing this. Some of the popular methods include diversification, limiting position size and frequency, hedging, stop loss and margin calls etc. Let’s look into each method separately.
Diversification, Limiting Position Size, And Stop Losses
Diversification is probably the simplest form of risk management technique. Simply said, divide your assets among multiple classes of securities. Many investment veterans diversify their portfolio among different types of investments. They believe that having too much position in one or two assets may not provide adequate diversifying benefits.
Thus, they prefer spreading their wealth across diverse sectors of industries. Another benefit of diversification is that, you don’t end up selling off your entire portfolio in case of sudden changes in markets.
Limiting Position Size And Frequency – The concept of limiting your positions was popularized by Ben Graham. His students learnt the hard way that frequent trades resulted in heavy losses. They realized that frequent large trades made them susceptible to bigger losses.
Consequently, they started putting limits on position sizes. When you limit how often you trade and how big your position size is every single time, you are susceptible to lesser losses. This would allow you to trade another day and try again with your analysis without the need to inject more capital to your trading account.
Hedging – Hedging involves using derivatives to reduce exposure to specific underlying assets or commodities. Derivatives help investors hedge the fluctuations of price movements. Basically, you use derivative contracts to limit your losses and lock in profits by buying protective instruments like puts, call options etc.
During turbulent times, you can easily purchase a put option(which gives you the right to sell shares) to shield your portfolio from falling prices. Alternatively, you may choose to keep your shares intact and continue earning money from dividends.
Stop Losses & Margin Calls – Stop losses refer to sale of shares at pre-specified levels. Once the price touches a pre-specified level, the broker or exchange (where you put your trade) sells the shares immediately to prevent it from going beyond that level. Usually, stop losses come into effect once a stock or crypto price starts moving down. Most brokers automatically place stops after a stock hits certain lows. Depending upon your broker, you may have no choice except to exit the position once the stock falls beyond the stop loss level.
Having the right stop losses, position size limits and intervals, and diversification will allow you to manage your risks properly in the always-uncertain markets like stock, crypto, and forex.
How to improve your risk management even further
You can improve your approach towards risk management even more. First of all, you need to understand market conditions – Before choosing any investment strategy, first of all, try to gain complete awareness about the current market situation. Understand whether the market environment is favorable enough to give you profit or whether it is suitable for protecting your capital.
Next, you need to be able to choose proper investment strategy – Select appropriate investment style based on your knowledge and understanding of the market. Choose a mix of styles that suit your personality and conditions. Remember, past success cannot guarantee similar outcomes in future. Instead, focus on building your skills and expertise in identifying new opportunities as well as avoiding mistakes.
Be Patient – Patience is a virtue. Always remember that patience is required regardless of whatever type of investment strategy you opt for. Never jump ship midway through a bull run, otherwise you’ll end up missing out on profitable opportunities.
Manage Costs – Manage your spending habits. Although costlier strategies offer higher returns, they also carry a higher chance of incurring substantial losses.
Use Leverage Appropriately – Use leverage wisely. Keep in mind that borrowing money from banks is expensive and risky. Only borrow money when necessary. Also in some brokers (with futures), they offer huge leverages to increase your position sizes. Always remember to not overleverage.
Keep Track Of Speculation Trends – Sometimes speculators find themselves locked into unprofitable positions for prolonged periods of time. Try to identify such trends early and implement corrective actions accordingly.
With the fast pace of the modern day trading world, it is becoming increasingly difficult to stay ahead of the game. The uncertainty associated with global economic conditions poses a serious threat to individual households and businesses alike. Staying updated with the latest news and information pertaining to the market trend is crucial to ensure successful investment plans. More importantly, adopting a disciplined approach towards risk management is equally essential to achieve desired goals successfully. Hopefully the above tips will be able to help you to stay profitable, especially in the long term, since risk management is more important than ever in these troubling times.