Three Practical Ways to Manage Your Risk in Investing - CommSec (2023)

Risk management is the practice of minimizing the potential for future losses in your portfolio. There are a number of tools and strategies that investors can use to try to achieve this and we will look at some of them below.

Three ways to manage risk when investing:

• Risk-Reward Ratios – help you determine your level of risk before making a purchase.
• Set a stop loss – remove emotion from your decisions by setting conditional orders.
• Diversification - Spread your investments across multiple sectors and industries so you are less affected by single events.

Implementing some of these ideas as part of your investment plan can help you develop sound investing habitslong term.

risk/reward ratios

Risk-reward ratios help you understand the level of risk you can handle while holding onto a stock. To use a risk/reward ratio, you need to determine your expected valueto returnAndRisk appetitesfor a particular stock - before you buy it.

For example, let's say you believe that one stock in your portfolio will yield a 20% return on your initial investment. There should be an associated loss level that you are willing to endure in order to achieve that 20% gain. You might decide you're ready to drop the stock 10% while waiting for it to deliver your 20% return. That means your risk-reward ratio is 2:1.

The ratio is a good planning tool when evaluating your portfolio because it helps you make rational decisions about your holdings. Hopefully, if the stock falls before it meets your expected rate of return, don't panic about what to do -- you've already decided how low you're willing to drop the stock before you sell it.

The risk level you calculate should be based on the stock's historical trading range. Does the stock tend to fluctuate around a specific high or low point and do you feel confident that it will stay within that range? You should also consider your personal risk tolerance and how much capital you would like to lose.

Remember that when your investment falls, you often need an excessive price recovery to recoup your original expenses. However, predetermining a risk level gives you the opportunity to limit your losses.

Conditional Orders

One of the most difficult decisions for investors is deciding when to sell an investment. This is especially difficult when the stock price of a company in your portfolio is falling rapidly. You might be concerned that the longer you hold onto the stock, your losses will increase. But then again, it's hard to let go of a stock when you know you're missing out on the potential for a recovery. What must a shareholder do?

A common tool used by investors to avoid these situations is what is known as a "stop loss" or "falling sell" order. This is an order that automatically places a sell order in the market when your share price falls to a certain "trigger" level. The trigger amount is whatever you choose based on your risk tolerance and risk to reward ratio. Determine a price at which you would be willing to exit your position down and set a stop loss when your stock price reaches that level. The conditional order allows you to further limit potential disadvantages.

You canSet up conditional orders¹Use of your CommSec account at no additional cost.Look for “Conditional Orders” in the trading menu.¹

It is important to realize that once your stop loss is triggered, the stock price still has potential to recover in the post-sell period. Although you may wonder if you sold too soon, it's an opportunity to examine your beliefs about the company in question and consider whether it could still be a worthwhile part of your portfolio. In this scenario, you should research the company thoroughly until you are sure that you are ready to invest again.

diversification

diversificationcan be used as a risk management strategy as it reduces the likelihood that a single event or situation could pose a major threat to your portfolio.

Although buying a larger number of shares will usually give you greater diversification, this is not guaranteed. It's important to look at the sector and industry into which each of your investments falls and to select companies in sectors that are influenced differently by market and economic forces. This reduces the likelihood that all stocks in your portfolio will fall at the same rate at the same time.

Investors pursuing a diversification strategy should seek to identify companies that have the ability to generate earnings growth in different conditions and times in the economic cycle. For example, an insurance company generates different earnings than a large retail or consumer goods company.

In the long run, proper diversification will help your portfolio weather the swings of market cycles and market downturns without suffering significant losses in value.

Let's finish

• A few simple risk management strategies can give you the framework to manage your portfolio and achieve your investment goals.
• Risk-reward ratios can help you determine what level of risk you are willing to take on an individual investment.
• Conditional orders can be used to automatically place a sell order if your stock falls to a certain price, limiting your potential for further losses.
• Diversification across companies affected by different economic conditions means your portfolio is less likely to be wiped out by a single event.