When it comes to investing our hard earned cash, what most people crave is certainty. That is, we want investments that will deliver a reliable return over a certain time frame, and indeed there are investment products that essentially do just that, such as term deposits and bonds.
However we also want to achieve the highest rate of return possible, and this is where we encounter somewhat of a dilemma. In the vast majority of cases, certainty and high levels of return are mutually exclusive. Sure you can invest in extremely low risk products, but you are unlikely to see returns that are sufficient to generate any real wealth, especially when the effects of inflation are taken into account. What these products offer is safety – a means of preserving capital with a modest return thrown in.
On the other hand, you can achieve very high rates of return through investing in business (shares) and property, but at the same time, you can never know with any certainty what your eventual return will be. Indeed, you face the possibility that you could lose a significant proportion, if not all, of your investment capital.
This isn’t news to experienced investors, who understand that risk equals return. That is, if you want high levels of returns, you have no choice but to accept some degree of risk. If you are not prepared to expose your investment capital to any risk, don’t expect to make any significant gains. This is the cornerstone of Modern Portfolio Theory, and a fundamental law of investing.
The trouble is that many people want to have their cake and eat it too. They want massive returns without having to accept any real risk. Others may at least understand that assets such as shares have some degree of associated risk, but don’t really appreciate the level of risk involved. This may be a result of ignorance or a consequence of poor advice from so-called professionals. Either way, a failure to properly account for the risk associated with any investment it is a recipe for disaster.
While we cannot avoid risk altogether when investing in the market, we can nonetheless act to minimize our risks considerably. Consider the following:
- Stop loss orders
These will ensure we exit any positions that move against us. Of course we will still make a loss but the idea is to minimize the potential loss. After all, losing 5% is better than losing 55%! People often view stop losses as a fool proof risk management strategy, but you should be aware of their limitations. Principally, there is every possibility that the share could rally after falling below your stop loss level, and people who set the stop loss points too close to the current price could find they experience this often. Also, take care to understand what will happen if the share price gaps below your exit point as many brokers do not guarantee stop loss orders.
There is a wide variety of ways we can insure our positions using a number of derivative products. While these methods will ensure we are protected from sharp falls but there is of course an associated cost. In situations where the stock is moving sideways or up, a hedging policy will only act to reduce your profit.
Diversification is a great way to protect you against unexpected falls in a specific security. The price you pay is that you ensure you achieve a more average rate of return than you would if you had only invested in the better performing stocks. So for those who can consistently pick the better performing assets diversification is not a good idea. If however you are prone to make a mistake from time to time and are prepared to sacrifice potentially larger gains for more security, then diversification is a sensible policy. Just ensure you don’t over diversify, as you will incur larger transaction costs and will only emulate the market average. (If you are content with the market average, it’s easier and cheaper to just buy into an index fund.)
No matter what method you consider you should always account for the worst case scenario and ask yourself whether or not you can accept this. If you can’t, don’t do the trade. And remember, there is no such thing as a risk free trade, period. There is however a big difference between a high risk and low risk trade and by ensuring you understand the risks and limitations associated with any particular strategy you will make more sensible and informed trading decisions.
Make the markets work for you,