Managing risks 101
Successful stock investors will tell you that risk management is very important. In fact, it is as important as learning how to pick the right stocks.
There are many reasons why managing risk is important.
One of the most important reasons is because everyone makes mistakes. Even the best and the brightest make mistakes. What sets successful investors apart is their risk management strategy.
It is important to stress that the size of an investor’s capital largely determines how much he can make. For example, someone with P100,000 will need to double his money to earn P100,000, while someone with P1,000,000 will only need to generate a return of 10 percent to earn the same amount.
Because of the importance of preserving capital to generate compounding returns, investors need to take steps to guarantee their survival in case they make mistakes. If ever they are wrong, potential losses should only be limited to a small portion of their portfolio.
In contrast, a fatal mistake could take an investor completely out of the game. This could happen when an investor makes a huge bet on a high conviction call that he thinks will allow him to get rich quickly. But a lot of things can go wrong. If the investors’ high conviction call takes longer than expected to materialize, or if what he thought would happen doesn’t happen, his mistake could cost him his entire capital.
Article continues after this advertisementHere are some steps you can take to manage risk:
Article continues after this advertisementOnly invest money you can keep for the long term. Numerous studies show that buying stocks is one of the best ways to boost investment returns over the long term. However, high returns come with high risks, and stocks are very risky because of their volatility.
An investor with a short-term investment time horizon could suffer significant losses if he is forced to sell his stocks at a bad time (such as a bear market) because of liquidity requirements.
To avoid this scenario, buy stocks using only money that you are sure you will not need in the short term. This would mean using money that you are setting aside for a long-term need such as retirement. Make sure that you have other sources of income outside of your stock investments. That way, you can ride out the volatility and take advantage of very cheap prices when fundamentally attractive stocks are sold down.
Minimize the use of margin. Using margin or leverage can boost investment returns. For example, popular AI stock Nvidia is up 144 percent year-to-date. If you used margin or borrowed money to double the size of your investment during the start of 2024, your return would be much higher at 240 percent, even if you factor in the cost of margin of 10 percent per annum.
However, using margin can also magnify losses. For example, what if you bought Tesla, which is 28 percent down? Since you doubled the size of your investment, your losses would be magnified to 56 percent. You would still need to pay the cost of borrowed funds so your total losses would reach 60 percent.
Another risk facing investors who use margin is a possible margin call. This happens when the stock you own falls significantly in price, leading to a steep decline in the value of your equity (total value of stocks you own less the value of your margin loan). When this happens, you might be forced to liquidate some of your stocks to meet your broker’s minimum equity requirement. You will need to do this even though the stock you own is very cheap and is being sold down for reasons that have nothing to do with fundamentals (such as index rebalancing).
Have a plan in case things don’t turn out as expected. For traders, this means having a price at which you will cut your losses if prices go down. For investors, this means having fundamental reasons why you will sell your stock.
Following your plan in case the stock doesn’t perform as expected is the most important part of having a plan. This is what will allow you to manage your risk and minimize your losses. For example, if the stock you are trading hits your cut loss price, make sure to sell. For investors, if the fundamentals of the stock that you bought changed for the worse, you also need to sell.
Don’t keep holding on to a losing stock. Although losses can be painful, remind yourself that the price of the stock you own could fall even further. INQ
