What risk management is
Any stock can fall, however good the company and however convincing the analysis. Risk management does not prevent losses and does not guarantee a profit. It is a handful of decisions made before the trade, so that when you are wrong, and everyone is sometimes, the loss is limited and known in advance.
Why a big loss is hard to undo
There is a simple arithmetic fact here: after losing a percentage of your money, you need a larger percentage gain to get back to where you were. The reason is that any later gain is earned on what is left, not on what you started with.
That is why the first aim of risk management is to never let a loss grow to a size that becomes very hard to recover.
Four questions before any trade
- Why am I entering?A clear reason you can write in one line.
- When will I know I was wrong?The price or event that, if it happens, means your reason is gone. That is what a stop loss is, and it has its own lesson in this path.
- How much will I lose if it does?In pounds, not as a feeling.
- What share of all my money is that?This answer sets the position size, the amount you put into the trade.
Some risks have nothing to do with a particular stock: the whole market falling, or needing the money suddenly and being forced to sell at a bad time. That is why many people keep money they will need soon separate from the money they put in the market.
Check your largest position
Record your positions in the portfolio and look at the risk panel for your largest position as a share of the total value of the positions you recorded.
Check yourself
1. You lost 20% of your portfolio. What gain gets you back?
2. What does risk management do?
Summary
- Risk management is a set of decisions made before a trade that keep the loss limited and known; it does not prevent losses.
- A large loss needs a much larger gain to be recovered.
- Before any trade: your reason, the point where you are wrong, the loss in pounds, and its share of your money.