Stock Market Risk Management
Stock market risk management is one of the most difficult skills for an investor to master. Investing in the stock market is fraught with worry, for good reason. If you lose half of your investment, you must double your return to just breakeven. Warren Buffett, considered by many to be the world’s greatest investor, states his first rule of investing is “do not lose money.” Unfortunately, the risk in the stock market of losing your money is always a possibility. However, without taking some risk there is no reward. Therefore, successful investors employ stock market risk management strategies to minimize their losses. Managing risk in stock market starts with identifying the type of risk and taking action to mitigate the impact of the risk on your investment portfolio.
Risk in the stock market comes in many forms and each can lead to a loss. The most common is the overall trend of the market. Approximately 60 % of the move of an individual stock is attributed to the trend of the stock market. If the stock market is rising, it takes with it most of the other stocks, though not in equal amounts. When the stock market falls, stocks sink with it. Part of managing stock market risk is being on the right side of the trend.
Another big risk in the stock market lies with owning an individual stock. While owning the stock of a company can offer greater rewards, it also entails the risk that something might go wrong that can cut the price of the company’s shares in half. It might be news that sales have suddenly fallen due to a new competitor, or a product liability issue has arisen. For whatever the reason, individual stocks are subject to risk associated to them alone. Diversifying your holdings is one of the best ways to address the risk associated with holding individual stocks.
While there are other risks in the stock market, these encompass the vast majority of the ones you will encounter. Fortunately, investors can employ several strategies as a part of their stock market risk management program.
First, they can invest with the trend of the market. Following the trend is a proven method to help manage the risk of the stock market, though it is not as easy as it sounds. Trend following tries to identify and then align with the underlying trend of the market. The assumption is the market will be in a trend that could last a day, a week, a month a year or multiple years. Generally, short-term trends cycle within longer term trends. Depending on your time frame, you can align your stock position with the trend once you have identified it. When you follow the trend, you are able to reduce the likelihood your stock will fall when the market trend is rising.
Another proven risk management strategy for owning stocks is to diversify your portfolio across several different companies, sectors, and asset classes. By owning several different stocks, you reduce the impact of a loss in any one company. Moreover, if the stocks you own are from several different industry sectors you mitigate the impact of any one sector causing a loss.