Brainy's Share Market Toolbox (public information)

Risk management

One very important aspect to protecting our investment capital is to carefully consider key elements of risk management

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Risk management? - How/why so? When investing or trading in the share market, it is important to be aware of the risks involved, and to mitigate the risks where possible, and minimise any possible impacts of adverse events. With appropriate risk and money management, the share market is not as scary, nor as frightening, as some people might believe it to be, and we can “sleep at night”. One way to tackle this is to look at all the things that could possibly go wrong, and then work backwards to consider how to mitigate these events - that is, perform a risk analysis to identify the risks, and then consider the strategies to mitigate the risks. We won't actually do that on this web page, but the following discussion addresses the mitigation aspects. A discussion on Risk Management with a risk analysis is included in Brainy's free eBook Article ST-4000, "Risk Management" (see More information links at right). Money can slip away - brokerage, commissions, slippage There are three things that can easily eat into profits: Brokerage (or the broker's commission), which is payable on each trade. Slippage - A small amount that reflects the actual buy or sell price compared to what was your "desired" or "intended" buy or sell price. Interest on borrowed funds. Depending on the size of trades, and the time for which the position is held, these items can eat away at the investment capital. Of course, larger position sizes can reduce the impact of brokerage fees and slippage. Assuming a brokerage fee of $20 per trade, it can be demonstrated that a parcel size of at least $1500 will help to mitigate these costs. And the impact of slippage can be mitigated by trading in heavily traded stocks - that is, avoid the thinly traded or less liquid stocks. We will be wrong One very important thing to understand is that it is not possible to be 100 percent correct with our investment decisions. This is difficult for some people to come to terms with - especially those who are professionally trained in some fields such as engineering, mathematics or science. You see, the field of Technical Analysis is not an exact science - there is an amount of "art" involved, and trading the markets based on technical analysis is actually playing on the likelihood of the future price activity. Some studies from some of the profitable experts conclude that a win rate of only 40 percent can still result in profitable outcomes. Provided we cut our losses quickly - to minimise the losses, and let our profits run. Provided we have wins that are larger than our losses, then the Win to Loss Ratio of 4 to 6 can still be achieved. Stock universe By giving careful consideration to your own stock universe, you can eliminate so-called higher-risk stocks from your portfolio. Just some of the considerations include: Liquidity - A majority of the stocks on the Australian share market can be considered illiquid, and trading in those stocks will increase the risk of suffering from significant slippage. Fundamental metrics - A number of fundamental metrics can be used to mitigate risks. For example, companies with a debt to equity ratio of about 50 percent or more are more likely to be stressed when the economic cycle turns and it is harder to borrow funds to finance company operations. So choosing companies with a low debt to equity ratio can mitigate this risk. There are several stock universe considerations - read more about them here. Good money management There are a number of strategies that can be employed to manage the investment capital in a sensible manner, including: Proportion of capital - 20% - Putting no more than a specific amount of the investment capital into any one investment position. One often talked about figure is 20 per cent of today's capital, but a more conservative figure is closer to 10 per cent. The Two Percent Rule - Allowing no more than a specific portion of trading capital to be "at risk". That is, if you want to invest for capital increase, and a position starts to go the wrong way, and you close the position, then the amount lost on this trade was the "amount at risk". This topic is discussed in a set of Presentation Slides "How to preserve capital...". This topic is discussed more in Brainy's eBook (PDF) Article ST-4100 (see link at right). Position size optimising - Very small position sizes (eg. $500) are just too small, because the brokerage will be a significant portion of the position, and the investment will need to work very hard just to cover the brokerage costs. The Two Percent Rule can be used to assist with optimising position size. Effective Exit Strategy - There are times when a company might fall on hard times, and their share price takes a prolonged tumble. Many astute investors who are keen to protect their capital might want to sell out, in order to avoid increasing losses. Exit Strategies Many investors still persist with the long-term buy-and-hold approach for share market investing. However, there are more and more investors who can see that in today's market conditions, such an approach is no longer the best one. Many investors are comfortable with selling some shares in order to protect their capital. But on what basis do they decide to sell? This is not straight forward, but they carefully pull together an Exit Strategy, which might be a simple Stop Loss approach. Read more about Exit Strategies...  Stop Loss A good Exit Strategy is very important in case the investment starts to go against us, so that we might cash in the position before too much is lost. One particular, and rather simple Exit Strategy, with share market investments is the humble Stop Loss - where we might determine a share price value before we enter the position, and if the share price falls to that level then we sell without question. This removes the emotion from the situation, and removes any discretionary aspect. See more about Stop Loss... Gauge the mood of the market Now this is not an easy topic to get one's head around. But let it be said that if one has a feeling for the overall mood of "the market", then one won't be surprised when the market behaves in a particular way. For instance - in early 2008 many technical analysts were not surprised when the world's markets crashed and suffered a bear market. By being aware of the overall market mood, these analysts were able to confidently implement capital protection strategies. Don't forget that a market correction, or bear market, comes around about every 4 years. Don't believe it? See more details... There are many ways to gauge the mood of the market. Just one method in the charts is to watch for bearish divergence. See more details about divergence (bearish and bullish)... More information For more information on these topics, refer to the web links above, and the references in the top of the right hand column.

More information Information in this Share Market Toolbox: Public presentation "Trading in Practise". Also eBook Articles - More details can be found in Brainy's eBook (PDF) articles, some of which are reserved for Toolbox members:: ST-4000 "Risk management" (publicly available to everyone). ST-4020 "How to reduce risks";  ST-4100 "The 2 Percent Rule";  ST-4300 "Risk and Reward";  ST-4400 "Position Sizing"; ST-4500 "Stop Loss". Robert writes information from time to time about the market and investing. If you are not a Toolbox Member, you can register to receive useful free information as it is published. Click here to register interest For Email Marketing you can trust Privacy ensured, unsubscribe anytime. See the Testimonials - the things that people say about the Toolbox and more. The Share Market - more information about the market and investing and trading. Brainy's Share Market Toolbox The toolbox is an arsenal of weapons to help you tackle the share market.   See a list of contents on the Toolbox Gateway page. Robert Brain provides various support to both new and experienced traders and investors. Who is Robert Brain? And whatever you do, beware of the sharks in the ocean!

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Last revised: 8 October,  2019