By Ee Hsin Kok. Edited by Arjun Chandrasekar.
You’ve probably heard the cliche “don’t put all your eggs in one basket,” and while it is a cliche, it isn’t wrong. No matter how sure you are of a trade or an investment, something can always go wrong. It is for this reason that learning how to manage your risk is a crucial step to being a successful investor and/or trader. In this article, we will introduce 2 fundamental risk management principles.
The 2% Rule
The 2% rule is a popular one among short-term traders, and it means that one should not risk more than 2% of their total capital for any single trade. For example, if you’re a trader with an account net liquidation of $10,000, and you find an opportunity to go long on Apple, no matter how confident you are in the trade, you should not be risking more than $200.
This rule exists to prevent traders from taking ridiculous amounts of risk and wiping out their accounts. It also helps to mitigate the damage done by a losing streak. Imagine you have a magical strategy with a 60% win rate and a 1:1 risk/return ratio. Even with such a high expectancy, there is a very good chance you will experience a streak of at least 12 losses in a row. This would mean a total drawdown of 21.3% for your account, which is still manageable. On the other hand, if you risked 3% or 4% per trade, your account would fall 31% to 39%, which would require gains of 44% and 63% respectively for your account to return to its original capital.
Note: Some successful traders (who are more risk-averse) are okay with taking risks larger than 2%, while other successful traders (who are less risk-averse or make a higher frequency of trades) use the 1% rule. What you ultimately pick is up to you, but the 2% rule is a good guideline for beginner traders to mitigate their risks and mistakes.
Diversification is the next main risk management principle, and this is more applicable for medium to long-term investors. By having a diverse portfolio of companies, investors are able to spread their risks across several sectors, industries and equities, decreasing the likelihood of bad news or scandals wiping out their portfolio.
For example, let’s say a guy named Adam has an equal allocation of 5% for 20 different companies varied across 10 different industries and 5 different sectors. If any one of Adam’s companies is involved in a scandal, his portfolio’s exposure is 5%. If any industry he’s invested in is hit with bad news, his portfolio’s exposure is limited to 10%, and if any single sector makes significant declines, his portfolio’s exposure is only 20%. On the other hand, let’s say his friend Bob doesn’t believe in diversification. Bob has a portfolio made of 6 stocks, 5 of which are in the technology sector, and 3 of which are in the software industry. If any stock of his was to be hit by a scandal, 16% of his portfolio is exposed; if the tech sector as a whole underperforms, 83% of his portfolio is exposed; and if the software industry has a crisis, 50% of his portfolio is exposed.
The two risk management principles introduced to you above are the 2% rule and diversification. These are fundamental principles for risk management, and a good understanding of them is crucial. Once you’ve mastered them, they act as a good starting point to dive deeper and learn more advanced topics regarding risk management such as correlation between multiple positions, hedging positions with derivatives, stock betas, and many more!