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Most investors like finding stocks they think will move. And most are eager to place trades. But they often overlook risk management because it’s less fun. This is one of the biggest mistakes people make when starting in the market.
Risk management helps you stay alive when trading stocks. Regardless of their time frames or strategies, avoiding the possibility of ruin should be the first thing all traders plans for. While it may be possible to survive for a short period without a plan for risk, eventually a trader will blow up if this key element is missing.
Even the best traders inevitably endure strings of losses from time to time. But by minimizing pain when it happens, they’re ready to get back in the game when new opportunities come along.
A common standard has recently emerged in the financial industry: Risk no more than 1 percent of total assets on any single position.
That way if an investor has a bad streak with 10 consecutive losses, their account won’t even shrink 10 percent. No one wants that to happen, but it can be survived.
While total portfolio risk is not a pleasant topic to think about, it is essential to having longevity in the business. If you know how much you stand to lose in any given situation, a weight is lifted off your shoulders. A sense of certainty about risk can help traders — good news in a business where no one single trade is guaranteed.
Since trading is based on probabilities and not certainties, traders must have a plan to mitigate risk in every situation.
All else being equal, a trader with poor stock selection and sound risk management will outperform and survive longer than the trader with great stock selection and poor risk management.
Too often, traders focus on entries rather than risk. They set their risk solely on how much money they will lose, how much pain they can take or an arbitrary percentage. A risk area should not be a random selection, but rather a well-calculated decision.
Traders expecting to hit home runs right out of the gate often set position sizes too large. This may work for a while in a calm market, but then they take a beating when volatility increases.
Something else is even worse: the psychological and emotional toll of being heavily invested in a strategy that stops working. Bad, reactive decisions often follow. Traders in such a situation find themselves grasping and doing all the wrong things at the wrong times.
Everyone knows that risk and reward go hand in hand. But we human beings have a tendency to ignore this in practice by overemphasizing potential gains over the very real possibility of losing money.
Never forget that accounts grow over months and years. Because it takes a long time, longevity and survival are key for all traders. We always want to live to fight another day, and that’s why no one can neglect risk management.
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