4 TIPS TO REDUCE TRADING RISK
The stock market is risky, so how do you reduce trading risk while keeping up big returns? In this post I’ve put together my four top tips to reduce trading risk, but first, you must undeerstand what is acceptable risk.
You should be willing to lose 50% of your expected annual gain.
Let’s use the S&P 500 as an example. There are studies that show the S&P gains an average 10% annually. Some say 7% when you factor in inflation. If you buy and hold, your average expected annual gain would be 10% (just to keep things simple). You should be willing to lose 50% of that expected gain, or 5%.
If you have been around the stock market for some time you know that the S&P 500 can drop that much easily, and does so a few times a year. On average, every ten years the S&P will drop 20% or more.
Many say if you buy and hold, eventually you will make money as the market always goes up in the long run. While this is true, most investors can’t hold when the holding gets tough. They panic, let fear in and sell. I’ll talk more about this in my 4 tips to reduce risk.
Your first tip is to have a plan, a trading strategy. Once you have a trading strategy in place, you will know you average annual return and you will be able to calculate your risk per the formula above.
Most mutual funds will show their 5 year annual gain. Get the average, then check financial history for the fund to see how much it drops in any given year. If it drops more than 50% of the average annual gain, it’s too risky and pass.
Question: Your portfolio is down 40%, are you investing in something that is too risky?
Answer: If what you are investing in routinely returns 80% or more per year, then it’s not risky. It’s expected for those types of returns.
Eliminate fear and greed. Traders let FEAR in and sell to soon, or sell to late. They let Greed in and hold too long, or too short, or buy the wrong things.
If you followed Tip #1, then you have a plan in place as to when you will sell. Now you must keep fear and greed out of your mind. Do not let it change your plans.
I have found the best way to do this, is to turn off the financial shows. All those “gurus” on there spreading fear and greed with their outlook on the markets.
In addition, avoid looking at the daily gains and losses of your holdings. If you started with a plan, then you already know when you will exit. Set an alert so that you will be emailed when your holding reaches it’s sell price (in case you want to evaluate whether to keep holding) or set an order to sell at a certain price. Set and forget.
Wait for right time to buy and sell. Don’t be impatient to jump in. If you hear everyone on TV and magazines saying what a great stock XYZ is, Don’t let greed trick you. By this time it’s too late to get in. You need to get in when no one knows about it.
Understanding technical analysis or fundamental analysis can help you pinpoint the right time to buy a stock or ETF.
Using alerts or trade orders can help with this. Just pinpoint the right buy price or sell price and set your order or alert.
Limit losses. I’ve seen traders freeze when they lose. Instead of selling they keep holding. “I have to get my money back” they rationalize. They are afraid of taking a loss. They end up throwing good money after bad as the stock drops more.
Keeping losses small, makes it a lot easier to recoup those losses on future trades. Lets say you lose 8% on a stock. All you need do is make 9% on the next one to break even.
$100 – 8% = $92
$92 + 9% = $100
Now lets say you let fear and greed in and didn’t sell. Now the stock is down 25%.
$100 – 25% = $75
$75 + 33% = $100
You need to gain 33% on the next trade. Here is one that loses 50%.
$100 – 50% = $50
$50 + 100% = $100
If you lose 50%, you need to make 100% on the next one to get it back, and that is not easy.
Treat trading and investing as a numbers game. Win more trades than you lose. Your average gain per winner is bigger than your average loss per loser = CONSISTENT PROFITS.
You can do it when you follow these four tips to reduce trading risk.