Managing risk is key to increasing one’s wealth. In the field of investing, this can be defined as the process of identifying, analyzing, and taking steps to mitigate uncertainty in investment decisions. Risk and reward are positively correlated. In other words, the higher the reward that an investor seeks, the higher the risk component, and vice versa.
How a Trader Manages Risk
Successful traders map out the potential risk of every trade before they place the trade. Even before placing a trade, though, the trader must ensure that their broker is credible and cost-effective for all types of trading.
Factors like high commission costs or wide bid-ask spreads will eat into a trader’s profits and add to their losses. The most straightforward way of managing risk is to set stop-loss and take-profit levels for every trade. These orders instruct the broker to buy or sell the security when price goals are reached. It is always good to make sure that the unexecuted order is canceled once one of these orders gets executed.
- A stop-loss order quantifies the potential loss of a trade, while a take-profit order quantifies the potential gain of a trade.
- Traders can limit the amount of equity used for each trade.
- Traders can use options, futures, or negatively correlated instruments to manage the risk as well.
How an Investor Manages Risk
The term “investor” generally refers to individuals who prefer the buy-and-hold strategy for wealth creation. These people tend to stick to traditional asset classes like stocks and bonds with a log-term time horizon. As such, they are not overly concerned with the short-term volatility that is inherent in financial markets. Thus, their approach to risk management differs from those who classify themselves as traders.
By and large, this investor approach follows the risk management template of identifying the risks, analyzing the potential effects of these risks on their portfolio, then taking steps to minimize or eliminate these risks.
Generally, this involves proper asset allocation based on the investor’s goals, diversifying to reduce portfolio risk, and taking advantage of short-term opportunities to improve the portfolio’s composition.
- Asset allocation refers to the optimal balance in assets between risk and reward to satisfy an individual’s long-term goals and risk tolerance.
- Diversification refers to a mix of different asset classes to not be exposed to the risks of any single asset class.
- Dollar-cost averaging is the practice of investing equal amounts over regular intervals to reduce the overall impact of volatility on the price of the target asset.