4 Trading Portfolio Risk Management Strategies
There’s no doubt that every investor wants high returns. It’s a topic that comes up in countless books, articles, and blog posts on how to “beat” the market. But is this the right goal to focus on? Fact is, the high returns will probably come if you focus on managing your risk – not your returns.
Just like bringing a second parachute to skydiving, risk management will help protect the money you make so you can have a long and consistently profitable trading career. After all, if you don’t keep your losses from exceeding your returns, you won’t be able to trade for very long.
Your risk management toolkit should be expansive since there is no single approach that works all the time. With that in mind, here are 4 risk management strategies that investors use to manage the risk of their portfolios.
Protect Your Portfolio’s Volatility
Any investment portfolio is subject to volatility, but to prevent loss of capital, you need to manage your volatility exposure. This will particularly depend on the type of trading instruments you choose since some stocks – like those in smaller or emerging markets – are inherently more volatile than others.
To track market changes, you can use tools like volatility surfaces that offer market data and analytics to model market volatility. However, you must also familiarize yourself with the concept and understand the different ways you can decrease your portfolio’s volatility to optimize your returns while minimizing the risk.
To generate high returns, your portfolio needs to be exposed to some risky assets. But since higher returns equal higher volatility, it’s best to diversify your portfolio within and across assets classes to offset the higher risk. Other ways to decrease volatility include hedging with short positions and hedging with options and volatility.
Create a Maximum Loss Plan
When investors choose the maximum amount they are willing to lose in a given period, they establish a maximum loss plan. Designed for cautious management of asset allocation, a maximum loss plan keeps investors from making bad decisions grounded in anxiety or fear about market movements.
A maximum loss plan may result in a more conservative approach to investing, but it should essentially lead you to only take calculated risks that are in line with your long-term plan. Although the approach helps you determine an appropriate asset allocation, that allocation isn’t necessarily fitting for every portfolio and will be unique to your goals.
Require a Margin of Safety
A margin of safety accounts for the difference between the intrinsic value and the price of the investment. The bigger the margin of safety, the less risk you take, and the greater your potential gains. A margin of safety will generally leave room for any judgment errors or unforeseen conditions.
Finding bargains, however, will not always suffice. Ideally, you want to find stocks that carry the characteristics of quality companies – like good management teams, healthy balance sheets, competitive advantage, earnings stability, innovation, and efficient operations. When a company isn’t of high quality, analyze the probability of improvement and adjust the price you are willing to pay by increasing your margin of safety.
You should, however, ensure that the company has at least one or two competitive advantages, or you’ll risk falling into a value trap. Competitive advantage will typically be company assets or abilities that are difficult to replicate.
Rethink Your Time Horizon
Most investors may fail in the long run because they try to outperform the market in time horizons that are too short. If you focus less on short-term performance and put greater emphasis on high probability strategies, you are more likely to generate long-term wealth. This approach requires determining or rather rethinking your ideal time horizon.
The issue with trying to beat the market in the short run is that it can lead to aggressive investments when prices are too high. However, the more expensive the market, the greater your focus should be on preserving your capital. Essentially, your focus should be on how your portfolio performs in the long run. If you get sidetracked in the short term and focus on factors other than valuation, you might neglect your investing principles.
Whatever investment approach you choose, risk management is critical to safeguarding your hard-earned savings and keeping your losses at a minimum. Remember that the larger your losses get, the higher the necessary return to get you back to where you started.
The 4 effective strategies for managing the risk of your portfolio are protecting your portfolio’s volatility, creating a maximum loss plan, requiring a margin of safety, and rethinking your time horizon. A good defense is your best offense when it comes to risk management.