Simple Risk Management Technique to Protect Your Portfolio
A person might take too much risk—knowingly or unknowingly—when it comes to their investments. Risk management is important if a person wants to preserve their initial capital and earn return on their investment with some certainty.
You don’t necessarily have to use advanced portfolio management techniques to manage your risk. Risk management can sometime be simple and doesn’t require a lot of calculations. At the same time, if investors manage their risk properly, they can take part in far more opportunities than a person who doesn’t consider risk management.
Unfortunately, when it comes to the world of investing, you are bound to come across an investment that will result in a loss—or leave a dent in your portfolio. At the core, risk management is simply about avoiding substantial losses in the portfolio.
The amount of risk an investor is willing to take is different from one person to another. As we all know, investors are risk-averse; in other words, they don’t like losing money. Risk management can be beneficial to those are looking for stability in their portfolio.
So, how do you go about managing risk in your portfolio? There are many different strategies for risk management, but there are few which can take out a significant amount of uncertainty from your portfolio without forcing you to do extreme mathematical calculations or purchase derivatives.
First of all, investors should spread their portfolio into different investments. Even if they are investing in one asset class, they should consider diversifying their portfolio. For example, if a person has $10,000 in their portfolio and they only want to invest in the stock market, it is wise for them to buy two or three different stocks in different industries. By doing this, investors reduce the risk of losing the entire portfolio—they have more than one holding, so that if one goes haywire, the other two will still be able to hold the fort.
Next, before entering into an investment, investors should consider the amount of loss and profit they are willing to take from the investment. In addition, the expectation of profit and loss should be realistic and something an investor can actually afford.
Suppose an investor is planning to purchase a stock of XYZ Inc. Before he buys, he thinks that the stock will rise about 20%. At the same time, he believes that if XYZ falls more than six percent, he will consider selling his position.
This way, the investor is able to identify his risk prior to entering the trade and, the best part: he knows what to expect in the best-case scenario and in the worst-case scenario.
Furthermore, most investors would just keep a losing trade in hopes that it will eventually rise when the market turns. Here’s a fact; if your investment goes down by 50%, it will have to go up by 100% for you to break even. What should an investor do if they have a losing position in their portfolio?
The ideal risk-managing technique in this case is to simply get out of the position. The investment will have to go up by a significant amount before an investor at least breaks even. Similarly, just by keeping money in a losing trade, an investor misses out on other opportunities ready to be taken in the markets.
Lastly, if an investment in your portfolio is doing great, consider taking some profits from it. Don’t be afraid; your worst-case scenario is still profit. The markets can turn quickly, and it doesn’t take a lot of time for a winning trade to turn into a losing trade.
Risk management is very important, because it can protect your investment portfolio from a significant drawdown. Keep in mind that these are only a few of many risk management techniques.