Risk management is an integral part of investing. Without it, investors might as well just hand their money over to other investors.
And because risk management is important, it’s also important for new investors to know the following tips. Following these tips can help achieve a better, more profitable trading experience.
Invest Money You May Lose
This is one of the golden rules of investing. To avoid being broke, only invest the money that you can actually afford to lose.
Do not use the money you use to pay for, say, your car insurance or home rental for trading. That’s because the risk losing money in the financial market is very real.
Just use your risk capital, which is money that you can afford. A good mental trick to do this is to consider the money as good as lost. What will happen? If losing the money means you’ll have no food for the next 30 days before you next paycheck, perhaps you shouldn’t risk it.
Mind Your Risk Tolerance
You can consider your risk tolerance by considering the following factors:
- Your knowledge of the financial market
- Your age
- Your skills and experience
- Your investment goals
- The amount of money you’re willing to lose
You must know just how willing and comfortable you are when it comes to taking risks. If you trade and you feel anxious and depressed after losses, your trading strategy may not be suitable for your risk tolerance.
Control Risks Per Trade
Without your trading capital, you can’t trade or invest. And if you lose it all in a single trade, will you be able to continue trading the next day?
The rule of thumb is to risk only a small amount of you trading capital per trade. Usually, professional traders only risk around 2% of their available capital each trade.
Learn about Leverage
Leverage basically lets you control bigger amounts of assets for a cheap price. The larger the leverage, the bigger the amount your control for a smaller price.
However, the catch is that when you lose, you lose huge. Even the smallest downturn in price may mean doom to your investment if your leverage is too large.
So, as part of an effective risk management strategy, learn all about and understand how exactly your leverage will work out for you. Do not use too high leverage, since the markets can very easily wipe out all of your capital.
Diversify According to Correlation
Another golden rule when it comes to risk management is the rule of diversification. It’s the art of not putting all eggs in one basket.
Diversification you don’t bet on only one kind of stock, currency, or asset. You seek different assets that will provide you with different advantages.
For example, to achieve growth, you invest in stocks that promise huge growth in the future. You want to see their prices going up in the medium term.
However, you also want to protect yourself from any possible market downturn. So, you also find noncyclical and defensive stocks. These stocks perform well even in market downturns and even when other stocks are slumping along with the economy.