"No pain, no gain.” How many times have you heard that cliché to describe something you didn’t want to do? Unfortunately, investing carries a certain amount of risk, and with that risk can come some pain, but also some gain.
All investments carry some degree of risk. The rule of thumb is “the higher the risk, the higher the potential return,” but you need to consider an addition to the rule so that it states the relationship more clearly: “the higher the risk, the higher the potential return, and the less likely it will achieve the higher return.”
To understand this relationship completely, you must know where your comfort level is and be able to correctly gauge the relative risk of a particular stock or other investment.
All investors need to find their own comfort level with risk and construct an investment strategy around that level.
Your comfort level with risk should pass the “good night’s sleep” test, which means you should not worry about the amount of risk in your portfolio so much as to lose sleep over it.
There is no “right or wrong” amount of risk; it is a very personal decision for each investor.
However, young investors can afford higher risk than older investors can because young investors have more time to recover if disaster strikes.
If you are five years away from retirement, you probably don’t want to be taking extraordinary risks with your nest egg, because you will have little time left to recover from a significant loss.
You can see that even a relatively small loss can require a pretty big offensive push to recover. It’s easy to say that you’ve got to control your losses. But how do you do it?
Follow the trend: The trend is your friend until it ends. One way to manage investment risk is to commit to only buying stocks or Exchange Traded Funds (ETFs) that are in an uptrend and to sell them once they violate their trend line support.
You can draw your own trend lines by connecting a series of higher lows on a chart, or you can use a moving average. If the price breaks that support level by a predetermined amount, you sell.
Rebalancing longer-term investors may try to manage risk by periodically selling stock investments or asset classes that have come to take up too much of their portfolios.
They will sell off those assets and buy more of the stocks or ETFs that have underperformed. This can be a forced means of buying low and selling high.
Position sizing: This is another way to play defence by simply limiting your exposure.
If a given investment is riskier than others, you can choose not to invest in it or to invest only a small amount of your capital.
The easiest way to lower your stock market risk is to shift some of your capital to cash.
Stop loss orders: You can place a stop loss order with your broker that will automatically sell out all or part of your position in a given stock or ETF if it falls below a preset price point.
Of course, the trick is to set the price low enough that you won’t get stopped out on a routine pullback, but high enough that you will limit your capital loss.
Placing a stop-loss order is one way to limit the damage to your portfolio and force yourself to follow strict defensive discipline.
Moving or ignoring stop-loss levels almost always results in greater losses in the end. The first exit is the best exit.
Diversification: The idea behind investment diversification is to buy asset classes or sectors that are not correlated. That means that if one goes up, the other is probably going down.
Diversification has been a lot more difficult to achieve over the past few years as many asset classes have become highly correlated.
