Managing risk

Attitude to risk

You can’t devise a sensible trading strategy without thinking carefully about your approach to risk. After all, even relatively safe investments may have some degree of risk, as there’s the chance you might lose money if the markets move against you.

We all have our own perceptions of risk, and an investment that seems like an exciting opportunity to one person may feel dangerous and stressful to another. It’s important to be comfortable with the level of risk you are taking on.

By taking some straightforward steps to control your exposure, you should find it easier to adopt a healthy and realistic attitude to risk.

Here are a few key methods you can use:

 

Diversification

You can help minimise your risk by putting your money into a broad range of different investments – in other words, not putting all your eggs in one basket. There are two main benefits in keeping a diverse portfolio:

Reducing the impact of individual losses
If you put all your investment capital into the shares of a single company, you risk losing most or all of your money if that company goes bust. On the other hand, if you buy shares in many different companies, your loss from the one that fails won’t have such a devastating effect on your overall investment.

However, even spreading your capital across a range of different shares can’t protect you completely. Your profit or loss would still be at the mercy of any economic factors that affect the entire stock market that contains your shares. 

Spreading your investment
This is the key to a balanced portfolio and is known as asset allocation. It refers to the way you spread your money across the asset classes – e.g. how much you have in shares, bonds, property and any other investments.

These asset classes often move independently of each other, or may even move in opposite directions to each other depending on their economic relationship.

You can also diversify within the same asset class, for example by investing in markets from different countries, or companies operating in different sectors.

Selected risk

You might choose to take on a few riskier transactions, if they contain the potential to make large gains. For example, you might decide to go long on a volatile asset if your technical analysis suggests that it’s likely to spike again imminently. See our technical analysis section to find out more about this.

Of course, there’s no guarantee that the same pattern will continue, but by combining your chart analysis with an assessment of your risk appetite, you can make an informed decision about which risky trades are worth pursuing and which aren’t.

Using a stop-loss

A stop-loss order enables you to limit your potential loss by setting a point at which your trade will be closed if the price moves against you. Please visit our orders section to find out more.

 

Examine your risk v reward ratio

It’s sensible to compare the expected returns on your investment with the amount of risk you’re facing to capture these returns.

To find your risk v reward ratio, you compare the amount of money you’re risking to the potential reward, and express this as a ratio.

So if the risk is $200 and the reward is $400, the risk v reward ratio is 1:2.

Take a look at the example below for details on how risk v reward ratio works.

Example: risk versus reward on Citigroup shares

  1. Let’s say that you buy 200 shares of Citigroup at $27 each (a $5400 investment). You place a stop-loss at $25 (when your investment would be worth $5000) to make sure you won’t lose more than $400.
  2. According to your chart analysis, you’re expecting the price to reach $31 in the next few months.
  3. In this case, you’re willing to risk $2 per share ($400) in the hope of achieving $4 per share ($800) on closing your position.
  4. As you stand to make double the amount you’ve risked, it can be said that you have a 2:1 risk v reward ratio.
  5. Finding your optimal risk v reward ratio will normally require some trial and error. Learn more about assessing your risk v reward ratio in our developing a trading plan module.
strategy_risk_vs_reward

Avoiding emotional trading

When making investment decisions, it’s important to distinguish between rational and emotional decisions. There’s really no point pursuing a ‘gut’ feeling that a certain stock will go up or down, unless it is backed up by firm analysis.

To find out more about the psychology that can influence your trading and the pitfalls to avoid, visit our common mistakes module.

It takes discipline to stick to your established investment strategy and implement it unwaveringly, without allowing yourself to be swung by emotional reactions brought on by stress or adrenaline. Knowing when to realise your profits and losses, especially if the markets are volatile, is an essential trait.

Creating a structured plan can help you to manage risk by recognising your goals and defining your strategy. To learn more, see our developing a trading plan module.