Risk management can take many forms— it’s what prevents you from torpedoing your kid’s college fund, for starters. But before you can do it, you have to define it, with a solid plan and cold, hard numbers. Here are a few ways how.
EDITOR'S NOTE: This article is second in a four-part series on the psychology of investing and trading. Read the first.
Risk management– The term itself is a bit of a red herring. Can anyone really, truly “manage” risk? Are we referring to the wars, hurricanes, financial crises and everything else that makes the world an uncertain place? Of course not. Warren Buffett, so the story goes, has a couple rules about investing. No. 1: Never lose money. No. 2: Don’t forget rule No. 1. Hmm. Easy enough for “The Oracle of Omaha” to say, but for us civilians, that may not be realistic.
There will always be risk, and even the best in the business can succumb to basic human emotions like fear and greed when markets go haywire. But there are ways to steel yourself mentally and distill this abstract concept into a coherent investing plan.
“Risk is more important than any other single factor when you trade or invest,” said Jeff Bierman, Chief Market Technician at TD Ameritrade. “If you cannot manage your risk, you can’t survive in this business.”
As you map out a risk management plan, consider a few fundamental guidelines to help keep your emotions in check and your profit and loss column in the black.
Start by allocating specific percentages of your overall portfolio based on time horizons and risk appetite. Then set limits on where you could lock in a respectable profit for a specific investment or cut losses if a position goes bad. A general rule of thumb holds that 80% should be designated for long-term investing (think in terms of several years), with the remaining 20% for more active positions (weeks and months).
There’s a little wiggle room here. Newer investors may want to allocate more conservatively—say, 90% for the long haul and 10% for shorter-term (trading) positions. Those with a bigger risk appetite may want to stretch it to 75% long-term and 25% for trading.
No single trade should put your entire portfolio at risk. Just how much are you willing to lose on a specific stock? Brett Pattison, Educational Resource Manager at Investools®, the education affiliate of TD Ameritrade, suggested a maximum capital allocation of 5% to 7% per position, with no more than 2% risk per position. For a sample $100,000 portfolio, that breaks down to $5,000 to $7,000 for one stock, fund or other investment, and a defined “stop-loss” limit of $2,000.
Stop-loss orders can be placed when you enter a position through tdameritrade.com or Trade Architect® and are triggered automatically if the price or value of a position falls below a certain level (see figure 1).
Avoid playing mind games with yourself: place stop-loss orders at the same time you enter a position. This helps you avoid second-guessing later on and tying yourself into emotional knots if a stock starts gyrating wildly. Think about your risk and reward on each position before you get into anything.
Another handy tool is the “trailing stop,” which moves in tandem with the stock price and can mitigate some psychological issues that often pop up as markets move—both in your favor and against you. Say a stock you bought at $100 with that 2% trailing stop climbs to $110, then drops. With that 2% trailing stop, your stop would automatically trigger a sell order at the next available price if the stock price falls to $107.80 or lower.
As the stock price increases, the trailing stop will increase according to the percentage that you define. This allows you to potentially cash out of profitable positions and helps relieve some of the pressure of getting out too early from a profitable trade. This differs from a “hard stop,” which is placed at a specific price and doesn’t move; it would need to be changed manually. Keep in mind that a trailing stop order will not guarantee an execution at or near the activated trailing stop price. Once activated, stop orders compete with other incoming market orders.
Know Your Options
Investors must determine their own personal risk comfort zones. It’s different for everyone. If you’re out of your comfort zone, odds increase that emotions will affect your decisions, and if a certain investment keeps you up at night, that may mean you’ve done something wrong. Certain options strategies, like bull and bear spreads, for example, can help you map out your risk limits and keep your emotions in check (see sidebar and figure 2).
Although they aren’t suitable for everyone, option spreads can help investors define risk as they enter a position and can be less capital-intensive than outright stock trades. Plus, you don’t have to rely solely on stop-loss orders and you can use the analytical tools available on Trade Architect to see how your positions stack up (see figure 3). You can also check out The Ticker Tape series from last year detailing basic options strategies, depending on whether you’re bullish or bearish.
Let’s face it—to make money, you need to be willing to deal with risk. So it’s crucial to adhere to a few sensible money-management rules. Don’t let yourself get intimidated or overwhelmed in the process. Look at this as a workout for your brain—challenge yourself to come up with “what ifs” and test how you respond to different scenarios. What’s that a wise person once said? Yep, mind over matter.