Anyone who has been involved in organized sports most likely knows the mantra, “Good defense wins games.” Coaches have been telling us that for years. The same is true when it comes to your trading and investing accounts. If you do not protect your money, you will not have it to make more!
To be successful in trading and investing, you need to fully understand the risks you will be facing. This is not to induce fear in you but to make sure that you have taken into consideration what you could be facing and to allow you to manage those risks.
Most investors have been told to diversify their portfolio. They think if they buy companies that are in different industries that they will be covered if there is some adversity in the markets. The problem is that they do not fully understand what risks exist in the markets and how to manage them. To trade properly, you need to understand the degree of risk you are taking on by involving yourself in the markets.
There are several risks that any trader or investor will face. Depending on the type of investment or trading vehicle we select, we will be exposed to one or many of these types of risk. The levels of risk are listed in order along with the securities that are involved at those levels.
Systemic Risk – These are shocks to the entire financial system where there are few to no safe havens left. We have experienced this with the collapse in 2008 in the markets, and perhaps even now with global economic powers showing weakness.
Asset Class Risk – Stocks, Bonds, Commodities and Currency markets all go through cycles where they are bullish or bearish. You face the risk of entering at the wrong part of the cycle for that asset class.
Country Specific Risk – Countries grow at different paces and can offer distinct opportunities and risks based on economic projections, political stability and other factors. We can trade ETFs and ADRs for companies based in other countries. We can even trade ETFs for the Indexes in the US like SPY, QQQ and DIA.
Sector Risk – There are nine sectors that companies fall into. The sectors also follow cycles where they are more preferred by investors and are bullish and also bearish. The sectors are: Consumer Discretionary, Technology, Basic Materials, Industrials, Energy, Consumer Staples, Services, Utilities and Financials. We discuss this rotation of sectors in our courses. There are several ETFs that we can use to trade the sectors.
Industry Risk – Within the nine sectors there are over 200 industries that are more specific to what the company does/produces. They also fall into cycles. We have additional ETFs that allow us to trade specific industries.
Company Risk – Individual stocks have risks from the company’s operations. Missing earnings, accounting irregularities and corporate member changes are all issues we face.
If you trade or invest in individual stocks you are exposed to the highest levels of risk. Even if you try to reduce risk by buying many stocks in different industries or sectors, you still have the asset class and company risk. When it comes to minimizing our risk, we want to be as high up the risk levels as possible while still maximizing our potential profit. When we increase our risk, we do also increase our potential for profit. You will usually see larger price movements on individual stocks than you do in ETFs, but the ETF can hold up much better than an individual stock if there is an issue with a company.
To really be diversified, you should invest or trade in multiple asset classes such as Futures or Forex to spread your exposure out over different asset classes. Even if you own a tech stock and a financial company, you will lose when the stock market collapses. Know your risks and manage them when trading. Success comes from protecting your capital as much as it comes from making winning trades.