Ways to manage risk: part one

Now we've looked at the main types of risk to keep an eye on, we can concentrate on how to manage those risks.

Always be aware of the downside

Before you place every trade you should calculate exactly how much you stand to lose in the worst case scenario. Remember that sometimes the market can move quickly or gap, meaning you might not be able to get out of your trade at the level you wanted to.

You need to keep the worst case scenario in mind, because if there's a major market event, you may be overly exposed. This is particularly important to remember when placing leveraged trades, where your losses could be greater than your deposit.

Avoid emotional trading

When making trading decisions, you should distinguish between those which are rational and those which are emotional. Relying on 'gut' feeling will almost certainly end in disaster, so it's vital to back up your decisions with clear analysis. As we've seen earlier, creating a structured trading plan can help you manage emotional risk by providing clear guidelines and helping you maintain your discipline.

Diversify

If you often have more than one position open at any one time, you can help minimise risk by putting your money into a broad range of different investments - in other words, not putting all your eggs in one basket.

For example, if you put all your investment capital into the shares of a single company, you risk losing it all if that company goes bust. On the other hand, if you buy shares in many different companies, your loss from the one that fails won't have such a devastating effect on your overall investment.

However, even spreading your capital across a range of different shares can't protect you from systemic risk factors that can affect the stock market as a whole.

Therefore the best way to diversify is to spread your investment across asset classes. For example, you may end up having a portfolio made up of shares, commodities, property, bonds and other investments. These markets often move independently of each other, providing protection against one particular asset class underperforming.

Select riskier investments carefully

If you do end up having a portfolio of different investments, it's sensible to balance out any particularly risky trades with more stable assets. The investment risk pyramid is a handy model to help you decide how to spread your risk across various financial instruments.

Select riskier investments carefully

Most traders will probably want to keep the bulk of their investments in safe assets that provide regular, if unspectacular, returns. These are represented by the pyramid's base.

In the middle there are medium-risk assets, which should provide a stable return and also have the potential to appreciate.

At the top are the higher-risk investments which have the potential for huge returns but large losses too. The money you put into these high-risk assets should only be money that you can afford to lose without serious financial repercussions.

Of course, the pyramid acts as a guide rather than a set of rules, so you'll need to think carefully about the amount of time and money you have to invest, and the level of return you want to achieve when choosing which assets to trade.

Lesson summary

  • You can't control whether a market goes up or down, but you can control your risk - so it's vital to have an effective risk management strategy in place
  • To manage risk effectively you should:
  • Always be aware of the maximum potential downside
  • Avoid emotional trading
  • Diversify your investments
  • Select riskier trades carefully
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