When it comes to the stock market, things can change rapidly. Numerous factors impacting the stock market can be translated into stock prices being up one day and down the next.
Though markets can be unpredictable, fluctuation is a sign that the stock market is functioning properly. As an investor, it's essential to get used to market volatility.
As a general rule of thumb of investing, the greater the risk, the higher the potential reward and the greater the potential loss. Figuring out your risk tolerance and learning how to manage risk can help you make informed investing decisions.
What's your risk tolerance?
Three main factors usually determine an investor's risk tolerance:
Risk capacity: How much can you afford to lose without affecting your standard of living both now and in the future? Risk capacity can vary based on age and personal financial situation.
Goals: How much do you need to earn to reach your financial goals, and what's your timeline for reaching those goals?
Emotions: How will you react to bad news? With fear and panic or with calm and control? How will these emotions affect investment decisions? Unfortunately, emotions and their effect can be hard to predict until they happen.
Risk management strategies
Why is risk management critical? Those who can preserve their capital during difficult periods will have a larger base to potentially grow from when good times return.
With that in mind, here are some strategies investors may use to manage the risk in a portfolio.
You've probably heard the expression, "Don't put all your eggs in one basket."
Diversification is a technique that attempts to reduce risk by allocating investments across various financial instruments, industries, and other categories. Diversification may help reduce the volatility of your portfolio over time.
Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk.
For example, say an original target asset allocation was 50% stocks and 50% bonds. If the stocks performed well during the period, it could have increased the stock weighting of the portfolio to 70%. The investor may then decide to sell some stocks and buy bonds to get the portfolio back to the original target allocation of 50/50.
Requiring a margin of safety
Value investors implement their margin of safety by deciding that they'll only purchase a stock if its prevailing market price is significantly lower than what they believe to be its intrinsic value.
The greater the margin of safety, the higher the potential for solid returns and the lower the downside risk.
Set stop-loss order
An investor exits trade with a stop-loss order if the predetermined price level representing a certain amount of loss is reached. By using a stop-loss order, traders may be able to limit their trading risks to a set amount in the event that the market moves against them.
(Note: Diversification and rebalancing are investment strategies that can help manage risk within your portfolio, but they do not guarantee profits or protect against loss in declining markets. Keep in mind that rebalancing may have tax consequences and transaction costs associated with it. There is no guarantee that any investing strategy will be successful.)
The best offense is a great defense
In investing as in life, you need to take risks to move forward. The key is to understand the nature of the risk, don't risk what you can't afford, and take steps to mitigate risks while pursuing your goals.
Think about it like driving a car. Proper risk control in investing is like driving a car with good insurance and obeying traffic rules, which will help ensure you get as far as possible while driving safely.
There are no guarantees in investing, but you can make an informed choice of the amount of risk you are willing to take and invest intelligently to reach your goals.