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Risk Management - The most important skill in trading and investing on stock markets!

Updated: Jun 12, 2022

What is risk management?

Risk management is the process of identifying, evaluating, and prioritizing risks, as well as the application of measures to reduce, monitor, and control the likelihood or impact of unfortunate events.

A risk management strategy is very individual and can vary from a simple set of rules to a complex evaluation of the whole portfolio and a number of processes to treat and monitor the risk.

How to develop and implement processes to keep losses under control and maintain a good risk/reward ratio?

Here is an example that helps you to define and implement risk management practices:

  1. Plan your investments. Even a simple planning of trades and the overall account will help you to identify, analyze and treat the risk. Ask yourself what will happen in the best and the worst case. Define actions like stops, exits, or hedging triggers.

  2. Distinguish between risk in single investments and portfolio risk. A best practice to manage the risk of single trades is the "1% rule", which implies that investors should never risk more than 1% of the total account value per trade. This can be modified according to your personal risk appetite and the volatility of assets you trade (2% - 5% ). Diversification in asset classes and consideration of "beta" (for more advanced approach) will protect your portfolio from systematic risk.

  3. Don't make it too complicated and find a balance of complexity that works for you.

  4. Be honest to yourself, be disciplined, and execute your rules like a robot. Your emotions will invite you to build on "hope" and this won't result as you expect in most cases.

Why do you need these rules and techniques even for small accounts?

You have to be aware that sharp, unexpected and massive moves (Black Swan effects) happened in the past and will occur in the future. Especially if you are trading a margin account, you have to be prepared for significant moves in all directions. There are many examples of "blown accounts" and traders who lost more than they possess ending deep in debt. Hence, managing risk will help you to increase financial success on stock markets and help you to avoid significant losses caused by unexpected events.

Losing money is a natural part of trading and making investments. However, be aware of the math of gains and losses. A loss of 50% requires 100% of gains to recover...

Loss $1,000 Gain to recover

-25% $750 33%

-50% $500 100%

-75% $250 300%

-90% $100 900%

Like Will Smith hit Chris Rock - the market will slap stock, commodity, options and even crypto traders and investors neglecting data and discipline.

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