There are many adages in the trading industry. A few of them are: “Buy low; Sell high”; “Nobody ever went broke ringing the cash register”; and “Bears and Bulls make money, but Pigs get slaughtered.” Interestingly, there is a motif underlying all of these sayings, and it has to do with managing risk. Trading decisions should be based on assessing the balance between risk and reward. While it is a natural instinct to want to maximize reward, it is equally as important to be disciplined and manage risk.
Some traders might naively ask, “Why does actively managing risk matter?” Answer: It’s not always because of risks that can be readily identified. Quite often it’s because of the risks that cannot be readily identified—unforeseeable events or occurrences. In the investment industry, these (supposedly) rare events are considered to be so remote, that they are completely unforseen. Unfortunately in today’s highly volatile markets, these types of events are not only more frequent, perhaps they aren’t as unforeseeable as they are thought to be.
It can be easy for traders and investors to become complacent with a stock market that continues to incrementally rise. Furthermore, it can be easy for traders and investors to become confident of their financial well-being and the benevolence of the markets. Truth be told, that will not always be the case. Again, as the saying goes, “What goes up will eventually come down.”
Traders might next ask, “What does risk management mean?” Simply, in the world of investing, managing risk is a process of establishing a discipline around protecting assets. Here are a few things investors may consider so that volatile events hopefully won’t feel as tumultuous as they appear to be:
- A diversified portfolio. It is important to diversify the holdings in any portfolio. While many active investors translate this to mean holding stocks in different sectors of the market (which, by the way, might be a good idea), it might also be a good idea to be diversified across asset classes (which can include corporate bonds, government bonds, and futures).
- An appropriate risk profile. Different investors are at different stages in their life. Younger investors may have a longer time horizon for their investing than older investors. Risk tolerance is a personal choice, but it’s good to keep perspective on personal time horizons, and manage risk according to when access to funds from different assets is needed. If cash is needed in the near-term, it is better to sell an asset when you want to sell it rather than when you have to sell it.
- Protection? People are very comfortable with the concept of protection when it comes to their health care, their automobile, or their house. It is also important to be familiar with the concept of protection of other assets, such as investment portfolios. There are investing strategies to specifically mitigate the risk of large, significant moves in stock prices. For example, the options strategy of buying puts is a basic one, but there are others as well. More on using options as protection can be found in the Education Center.
- Remain calm and be disciplined. It is very easy for an investor to lose their head in the madness of dramatic market moves—but it’s important to realize that this is just part of how markets work. It is not necessary to be active just because there is action in the markets. In the midst of the firestorm it can be easy to lose perspective and miss the forest for the trees. Sometimes a little break is all it takes to regain proper perspective. Keep in mind the longer-term view of personal financial goals and maintain discipline.
Now comes the trickier part. It can be easy to understand why managing risk is important and what it might mean to different traders. However, developing a risk management discipline can be a little more difficult. There are some incremental steps traders can take to put them on the path to managing risk.
Do the homework. Advice on a “hot pick” from the neighbor’s cousin’s friend might sound like a great trading idea, or it might not. Traders have to really make those decisions themselves, which includes understanding what is going on in the broader market, as well as understanding what is going on within individual stocks.
When looking at individual stocks, there are two different ways to analyze whether a particular stock may be a good investment: fundamental analysis and technical analysis. Fundamental analysis is evaluating a company based on economic and financial factors. Examples of fundamentals include price to earnings (P/E) ratios, earnings per share (EPS), and return on equity (ROE). Technical analysis, on the other hand, is looking at movement in a stock’s price to try to identify trends. Examples of technical analysis are 52-week highs and lows, or moving averages.
E*TRADE has tools available to help research the broader markets, research different sectors, and even screen for stocks based upon both fundamental and technical strategies. To learn more about using fundamental and technical analysis visit the Education Center.
Be disciplined, manage risk
It is wise for investors to gain as much understanding of a variety of investing tools as possible. Having a variety of tools, knowledge and skills will allow an investor to achieve greater diversification and potentially have a greater discipline to manage risk. In turn, this may give an investor the opportunity to take advantage of different market conditions, and may give them the best likelihood to have a positive investing experience.