Welcome back to this Smart Money Club Technical Trading Basics lesson. Our last lesson taught you the different types of risk and how those risks can potentially affect your investments. We want to take your trading to the Power of X with this lesson, introducing some methods to manage risk. Risk management is an essential aspect of successful trading of all types. Too many people neglect risk management principles and suffer the consequences of that neglect. Let’s not make that mistake.

Always Acknowledge the Downside

One step to take before you make any trade is to calculate the worst-case scenario and how much you could potentially lose. This eye-opening step can prevent you from making some bad decisions. Remember, sometimes the markets can move very quickly; they can also “gap,” which means that you are unable to get out of a trade at the level you wish to close it. When you consider the worst-case scenario, you are prepared for any significant market event. You will not leave yourself overly exposed. 

If you are making leveraged trades, then this particular step is vital. With leverage, you are putting yourself in a position to have greater losses than your investment if a margin call is made.  

Don’t Trade Emotionally

Another risk reduction step is to only make trades with a reason behind them. When you make trading decisions, you need to distinguish between trades that are rational and those that you make due to emotions. Fear of missing out (FOMO) buying or panic selling can wipe out your portfolio in no time. 

To rely on your gut feeling will eventually end in disaster. It is vital to back up every trade decision with precise analysis. You want to develop a structured trading plan that will help you manage your emotional risk. This planning is a way that can help you manage the emotional risk. It will provide you with clear guidelines and help you maintain your trading discipline.  

Diversification Can Reduce Risk

Having more than one position open at a single time can help you minimize your risk, by selecting a broad range of unlike investments reduce the risk further. Quite simply, not putting your eggs all in one basket.

As a simple example, you are increasing your risk if you take all of your investment capital and buy shares in a single company. You lose everything if it goes bankrupt. If, on the other hand, you take the same amount of money but you purchase shares in several different companies, in different sectors, of different sizes, and maybe even different countries, your loss as a result of one of those companies falling or even going broke will not have a significant impact on your total investment portfolio.  

However, remember there is systemic risk, and even if you spread your capital across a broad range of different equities, you can’t protect against systemic risk factors that affect the market as a whole.

You can therefore diversify your investments also to include different asset classes. Not only buying stocks but commodities, bonds, real estate, and other investments. These markets move independently and provide even better risk reduction against an underperforming class.  

Higher Rewards Come With Higher Risk so Choose Risky Investments Wisely

If you have a diverse portfolio, you will want to balance it so that for the risky positions that you have, you should also have more stable investments. The following risk pyramid of investments is a simple tool you can use to determine what allocation you should devote to assets that have a particular risk profile.  

The lower the risk, the larger proportion of your portfolio they should make up. As you move higher up the risk level, the proportion of your total portfolio should decrease. The pyramid also includes investments from several classes to make placement and identification easier.  

The majority of traders will want to keep the largest share of their investments in safe assets that provide unspectacular but regular returns. These investments make up the pyramid’s “Base.” The “Middle” risk level assets provide a stable return while also having the potential to appreciate. The “Summit” of the pyramid can provide for huge returns but is susceptible to large or total losses as well. Money that is invested in the Summit should only be money you can afford to lose. As you get older, closer to retirement, the size of the Base will widen, and the Summit investments will make up a smaller percentage of your total portfolio.  

Remember, this pyramid is only a guide, not a defined set of rules, so think carefully each time you invest.

Summary

With any investment, make sure that you can afford to make and lose it, and it is a thought-out nonemotional trade. Diversify into several asset classes and follow the rules of the risk pyramid, selecting risky trades carefully. You will be on a path to the Power of X.