How Risk Management Should Guide Every Stock Trade

Risk management should guide every stock trade. In fact, before we invest a single penny, we should have a risk management strategy in place to protect our capital. We’ve all heard it before in one form or another… risk and reward are inseparable. But that doesn’t mean we need to take unnecessary or “big” risks, especially when it comes to investing. Don’t be fooled… those type of risks are what “gamblers” do, not investors.

 

At Invest in the Markets, we approach investing with three primary objectives: to protect capital, to minimize risk, and to maximize returns. As you’ll notice, two of the three are “defensive” in nature… which is what keeps our investors from experiencing huge declines in their portfolio’s value or sleepless nights due to market corrections. It’s not that we take out all the volatility and uncertainty out of trading; rather, we take advantage of upswings in the markets while reducing our positions when the markets dip down.

Today, we’ll take a moment to define “risk management” prior to discussing some common investing myths that devalue risk management. Then, in the following days, we’ll return to explore some practical steps investors can take to manage their assets. But before you read on, take a moment to enjoy this brief Seinfeld Risk Management clip.

Defining Risk Management

The textbook definition might read something like this: Risk Management is the process of identifying, assessing, and prioritizing the perilousness of the situation in order to be able to coordinate efforts to minimize, monitor, and control the impact of unpredictable events and maximize the results of opportunities (modified from Wikipedia). When we break this out, we notice a few key characteristics:

  • An Acceptance of Uncertainty – Investing involves uncertainty… and if we’re unwilling to accept some inconsistencies, then we will be disappointed. But, if we can accept that uncertainty exists, then we’ll be better prepared to stop trying to predict market direction and focus more on preparing for market trend changes.
  • An Ongoing Process – There are no books, computer programs with different coloured lights, nor advisors who can provide the ultimate trading system that will never need adjustment. Furthermore, just when we feel that we’ve prepared for the uncertainty, a new world event or market crisis will emerge, causing us to reevaluate our presuppositions.
  • An Opportunity for Prosperity – As we accept the uncertainty and make adjustments to our plans, we learn to prosper in good and poor market conditions. We do this by protecting our capital, thus controlling the uncertainty, and by taking advantage of the market trend. With each moment of flux comes opportunity and risk management helps us identify these opportunities and take advantage of them.

Fear Controls Investors

Fear is real… especially among investors. And the older we get, the more likely investors will feel the impact of that fear in their investment portfolios… for our need to use our savings gets closer and our ability to generate new wealth diminishes with the years of our lives. That’s why most investors believe it is necessary to lower the amount of exposure to “risky” assets as they age. Personally, the categorization of “risky” assets is often misconstrued. Nevertheless, fear is a real and sometimes healthy emotion and it is particularly evident when things are not going well.

Investing Myths that Devalue Risk Management

Most investors and advisor will not come right out and denounce risk management. Yet, many devalue risk management by their very actions. They offer advice and defend it with shades of grey, often for their own good, not the good of the investor. Remember, many “professional” advisors make money based on the average investor keeping and adding to their investment portfolio. If they don’t have investors using their services, they don’t get paid. But I digress…

Here are some ways investors and advisors alike will sometimes denounce risk management indirectly:

  • It’s Too Late to Sell – Have you ever owned a stock that has dropped significantly enough that you feel it is too late to sell? So, instead, you might even throw more money at it as it circles the drain… In fact, one of the main reasons investors lose money is because they chase losing stocks.
  • Buy the Right Stock – Some investors believe if you simply buy the right stock, you’ll be fine. Often, they’ll use fundamental analysis to determine what stock is right for them. Let’s say you did just that… and determined that BP would be your stock of choice. So, in 2010, upon seeing some recovery in the stock, you purchase BP shares… and then it happens. The oil spill… cutting the stock price by 52% or more. Now, some people are quick to point out that if they simply bought then, it eventually climbed, at least a little. Well, then take Enron… or Oilexco… or… the list is endless.
  • Dollar Cost Average – I suppose nothing more needs to be said with these past couple of examples. But, take away the doom and gloom stories and we are still left with the question, “Why invest in a stock that is dropping in value when we could be making money by investing in a stock that is rising in value?”
  • Plan your Purchase, Not your Sale – Investors often put lots of effort into planning their purchases without any thought toward an exit strategy. Unfortunately, this effort on the front end without thought toward the last transaction can lead to unnecessary losses.

Join me in a couple of days when we’ll look at some specific ways investors can develop and apply risk management techniques in order to help you Preserve Capital, Minimize Risk, Maximize Returns. It’s not a hollow motto… it’s a statement of guiding principles at Invest in the Markets. It’s a commitment to an investment process that accepts and prepares for uncertainty while looking for opportunities. Most importantly, it’s an acknowledgement that risk management should guide every stock trade.

24 Comments
  1. Very impressive… excellent material, great concepts, clearly laid out. Thanks for the hard work.

    • Thanks Jessica… I appreciate the kind words.

    • Agreed! I’ve been finding it very hard to find articles that are between for-dummies (where I get bored) and for-pros (where I understand very little) so this is great! Keep it coming, love to learn more!

      • Thanks Andrea. That’s very kind and encouraging. Your feedback helps me keep on track and know that it’s useful for people like yourself, so keep the feedback coming too!

  2. Really like that you discussed having an exit strategy. While we all hope that our investments do well, there is no guarantee of that and having an exit strategy can save time and alleviate stress.
    Pam at MoneyTrail recently posted..Budgeting the Holiday Wish List with Older Kids and TeensMy Profile

    • Thanks Pam… I appreciate your comment. You’re exactly right… none of us invest thinking things won’t go well, but if they don’t or even if they do, having an exit strategy does reduce stress and saves us money too!

  3. How do you keep track of your ROI? do you use a spreadsheet or anything? I’m trying to look for a excel template but can’t find one.
    Aaron Hung recently posted..Should you buy a home in this economy?My Profile

    • I have been developing a spreadsheet… just tweaking bits and pieces. I’d be happy to let you know when I’ve got it to a point I’m willing to distribute to others!

  4. “Plan you purchase, not your sale” great advice for any investment. Like the saying goes, you make your money when you buy, not when you sell.
    Shaun @ Money Cactus recently posted..The Value Proposition: How to Make Sales and Influence PeopleMy Profile

    • Actually, I was demonstrating that there is an intrinsic flaw in only planning the purchase, not the sale. It’s a myth that devalues risk management… you make money when you sell, not simply when you buy.

  5. Great work I think risk assessment should be a part of everyday life, not just in the stock market,.
    Jeff @ Sustainable Life Blog recently posted..Where I Get the Most ValueMy Profile

    • Thank Jeff… you’re absolutely right. Risk management is a part of life, yet many people don’t consider it when investing.

  6. One of the first things that I had to do when I started looking at investing was my risk tolerance level. I haven’t gotten to the point where I have been tracking everything as closely as I should. The biggest thing I got out of this is knowing that I will need an exit strategy at some point.
    marissa recently posted..The fastest route is rarely the most direct one: three things that bring immense value to my lifeMy Profile

  7. Good post. You and Shaun have it right-you make your money at the beginning.
    Dr. Dean recently posted..Friday Follies: Exchange Students Rock Edition!My Profile

    • Hmm… perhaps I wasn’t clear enough… What you do at the beginning is critical, but the issue is really planning for the next steps after the purchase is made. Let’s never forget that you don’t make money until you sell the position and put the profit in your pocket!

  8. The uncertainties in stocks, shares, money etc these days make it difficult to find a profit except in the old favourites of property and gold. But perhaps I’m wrong. Will look forward to your next installment…
    John@MoneyPrinciple recently posted..Love drop: do something worthwhile this ChristmasMy Profile

    • Thanks for the comment John. You’re right… there has been some tremendous uncertainty and the markets in 2011 have been extremely difficult to trade. But there are still some opportunities… even outside property and gold. HANS, DLTR, AAPL, MCD, etc. have done well this year among so many others.

  9. Great advice! Like how two of your three objectives are defensive in nature. Too often investors go offensive and aggresively chase gains. Not enough time and effort is put on the defensive side. What if your trade goes the wrong way?
    Buck Inspire recently posted..BI 003: HMO vs PPOMy Profile

    • Absolutely… it’s an intentional approach to investing that helps ensure I’m on the right side of the trade in any market conditions.

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