Risk Management: A Simple Guide for Investors {update}

Diversification: Don’t put all your eggs in one basket.

Diversification is one of the most effective ways to manage the risk. It’s spreading your investments across many different assets like stocks, bonds, and real estate. The idea is simple: But if one lowers, others may still function well balencing out your total attack.

For example, say you only invested in one company’s stock. Then if that company has problems, you might well lose a lot of money. Now, however if you invest in multiple companies and industries, the effect of one bad performing one is decreased. The lower your risk, the more diverse your portfolio.

Investopedia is a good place to learn a bit more about diversification.

Stop-Loss Orders: A Safety net for your investments.

In risk management, stop loss orders are also a major tool. These limit your loss on an investment. A stop loss order is when you place a price at which your asset will be sold if it starts going down. It helps you cut your losses and not continue the decline.

Let’s say that you buy a stock for $50 and set a stop loss order at $45, the stock will sell itself automatically by that point. In this manner you do not have to constantly check the stock and at the same time are protected from loosing too much money.

For more detailed information about stop loss orders, see Moneyphobia.

Position Sizing: Know Your Limits

They also consider another aspect of risk management, that is, position sizing. That means determining the amount of capital you’re willing to put on the line with a single trade. The important part about this is because even the most experienced investors can lose. With too much risking on one trade, the loss of one can wipe out the investment.

They use a common rule of thumb, placing the risk on a single trade at no more than 1% to 2% of your total capital. Suppose you have $10,000 you want to invest, say you should only risk anywhere between $100 and $200 on any one trade. That way if you put the trade against you, you have enough capital to continue trading and recoup.

Managing Emotions: Stay Cool Under Pressure

Investing can be emotional. Decisions are often made out of fear and greed, thus mistakes. Risk management is about managing your emotions. You can lose huge amounts of money by sticking to your strategy and avoiding impulsive decisions.

Journaling. By writing down each trade afterwards, you will be able to think back on the decision making process that went into the trade. It helps you stay on track with your strategy and make it easier to notice patterns in your behavior.

Learning and Adapting: Continuous Improvement

Risk Management is not a one hit wonder. It requires repetition, that is, continual learning and adjustment. Once things change, risks change and so do markets. It’s important to stay informed on what’s happening in the market place, the economy and what may pose risk.

Financial news sources such as outlets or investment blogs, like Moneyphobia, are also available to you to keep yourself informed of the most recent trends and strategies. Refining your approach can also be a result of learning from your experiences and other people’s.