Risk management is critical to long-term investing success, but it is often disregarded by retail investors focused on returns.
Losing money as retail investors can be catastrophic due to compounding investment returns. That’s why Warren Buffett has just two investing guidelines.
- Rule #1: Avoid losses.
- Rule #2: Remember rule #1.
There are six risk management measures that retail investors should know.
1. Focus on allocations.
Investing exposes investors to a variety of risk and return considerations.
Rebalancing allows investors to obtain extra returns by keeping asset allocations top of mind. It allows you to make short-term tactical investments in undervalued asset sectors, classes, or industries.
The choice between equities and fixed income is the first step. After that, allocations between sectors, geographies, industries, and growth characteristics.
These decisions include whether to invest passively or actively. In addition, whether to outsource some of your portfolio to external experts.
2. Set limits on investments to avoid behavioral biases.
Investing may be a mental as well as an intellectual endeavor.
Constraints assist control risk exposure to various behavioral biases and portfolio elements. Retail investors should follow the same tight guidelines as large institutional investors. Following are instances of common restrictions affecting retail investors.
However, constraints are useless if you don’t follow them. Therefore, it’s good practice to write down your limits so you don’t ignore or forget them.
In addition, sharing your concerns with a partner, spouse, or investment buddy might help you keep on track.
3. Invest with a safety margin after doing your homework.
Valuation investors recognize that genuine risk comes from making poor investment decisions that result in permanent losses.
However, thorough research of your investment ideas can help reduce this risk. Therefore, always have an estimate of intrinsic value.
Furthermore, always buy with a safety margin. Additionally, always keep track of this amount in a spreadsheet when a company’s intrinsic value shrinks or grows.
4. Investors should have a cash reserve or emergency fund.
One of the worst things that may happen to investors is being made to sell. Therefore, to avoid this danger, never overextend your portfolio.
Furthermore, always preserve 3 to 12 months of living needs in cash. With this risk management method, investors may endure a +25% decrease in the markets without incurring the margin call.
Cash can also be short-term investment instruments like high-yield savings accounts. However, make sure your emergency fund or cash reserve is earning interest so you can benefit from the compounding interest!
The quantity of an emergency fund varies depending on employment stability. Stockbrokers or realtors, for example, are more cyclical occupations. Therefore, their emergency funds should be larger to reflect this risk. In addition, prepare for immediate major expenses with a cash reserve.
5. Retail investors should have stop-loss or stop-limit orders in place.
These orders limit losses to a percentage (say 10%) of the market or original purchase price.
Therefore, if the stock price goes below the stop-loss level, the order is filled at the market’s next available price. Additionally, limit orders guarantee a minimum price. However, they may not be completed if prices decrease too rapidly.
You can place stop-loss orders on any stock holdings that an investor is wary of. Furthermore, they can free up time for ordinary investors to do other things.
Whether investors are on vacation, at work, or on the golf course, their stop-loss orders are minimizing losses. In addition, to protect capital gains, investors should adjust their stop loss trigger prices if their equities appreciate in value.
Stop-losses can also help eliminate loss aversion, where investors cling onto losers in their portfolio and sell winners too early due to the discomfort of realizing losses. Therefore, if a stock falls below a certain level, the initial investing thesis may have been at fault. Automatic selling with stop-losses removes the risk of loss aversion bias.
6. Use protective put options as needed.
Options are generally associated with producing extra revenue (writing call or put options). However, they can also be used to reduce risk (purchasing put options). It allows the owner to sell the underlying securities at the strike price before the expiration date.
Buying a put option on a security or broad market index that is already owned in the portfolio helps prevent losses. Using protective put options makes sense when things get pricey or hazardous, just like getting home insurance.
This method allows an investor to keep partaking in the market’s upside while reducing the downside. Staying invested in the market and collecting dividends helps offset the “insurance premium” expense.
The Takeaway for Investment Risk Management
Managing portfolio risk is critical to long-term investing success. Investors must be aware of and manage their portfolio risks. Do your research and buy with a margin of safety. However, always remember that unusual things can happen. Therefore, plan ahead and avoid swimming naked when the tide goes out.