Having good risk management practices is fundamental to any trading or investing strategy, as it will help to keep potential losses in our pockets. As the Oracle of Omaha always puts it “Rule #1 is not to lose any money, and rule #2 is never to forget rule #1”. At the end of the game, long term success will only be achieved if we live to fight enough days and get the necessary experience.
With this in mind, here are five simple Risk Management tips that any trader or investor should take into account when navigating the markets.
- Asset Allocation: This one applies more to an entire portfolio than a single trade. Essentially this means to diversify across the types of trade you hold at any given moment. The diversification can apply to different companies within an industry, different industries in general, even trades with different time horizons, or using puts and shorts to hedge positions.
- Position Sizing: Position sizing refers to the portion of your complete account that you are using to buy an asset. If you are looking at the screen every second and twitching with every tick, then probably you have not developed the mindset to handle that amount of money. The good part is that if you are serious in becoming a trader, with every trade you make your tolerance goes up which allows you to keep placing bigger bets.
- Buying in tranches: Basically this means not buying the full position in one go. You could buy in halves or thirds. This will allow you more time to manage a trade and make sure you are feeling comfortable, especially in tricky markets.
- Use stop Losses: For traders we must keep in mind to take small losses quickly, for investors this is a bit less so. Depending on the strategy you can use different type of stops such as trailing stop losses either with percentages or absolute values. Hard stop losses which is an order at a specific price. Or closing day stops where you sell the next morning if a stock closes the day below a certain price.
- Review your time horizon: there are many different strategies that are played in different time horizons. For example, day trading is extremely fast making multiple trades per day. Momentum and swing trading you hold either a day to a couple of weeks. Value investing you can hold anywhere from a couple of months to years. And finally things like dividend investing you would hold to forever.
Thoughts of a Psycho Trader…