Stock market risk management is one of the most difficult skills for an investor

to master. Investing in the stock market is fraught with worry, for good reason
. If you lose half of your investment, you must double your return to just break
even. Warren Buffett, considered by many to be the world s greatest investor, stat
es his first rule of investing is do not lose money. Unfortunately, the risk in th
e stock market of losing your money is always a possibility. However, without ta
king some risk there is no reward. Therefore, successful investors employ stock
market risk management strategies to minimize their losses. Managing risk in sto
ck market starts with identifying the type of risk and taking action to mitigate
the impact of the risk on your investment portfolio.
Risk in the stock market comes in many forms and each can lead to a loss. The mo
st common is the overall trend of the market. Approximately 60 % of the move of
an individual stock is attributed to the trend of the stock market. If the stock
market is rising, it takes with it most of the other stocks, though not in equa
l amounts. When the stock market falls, stocks sink with it. Part of managing st
ock market risk is being on the right side of the trend.
Another big risk in the stock market lies with owning an individual stock. While
owning the stock of a company can offer greater rewards, it also entails the ri
sk that something might go wrong that can cut the price of the company s shares in
half. It might be news that sales have suddenly fallen due to a new competitor,
or a product liability issue has arisen. For whatever the reason, individual st
ocks are subject to risk associated to them alone. Diversifying your holdings is
one of the best ways to address the risk associated with holding individual sto
cks.
While there are other risks in the stock market, these encompass the vast majori
ty of the ones you will encounter. Fortunately, investors can employ several str
ategies as a part of their stock market risk management program.
First, they can invest with the trend of the market. Following the trend is a pr
oven method to help manage the risk of the stock market, though it is not as eas
y as it sounds. Trend following tries to identify and then align with the underl
ying trend of the market. The assumption is the market will be in a trend that c
ould last a day, a week, a month a year or multiple years. Generally, short-term
trends cycle within longer term trends. Depending on your time frame, you can a
lign your stock position with the trend once you have identified it. When you fo
llow the trend, you are able to reduce the likelihood your stock will fall when
the market trend is rising.
Another proven risk management strategy for owning stocks is to diversify your p
ortfolio across several different companies, sectors, and asset classes. By owni
ng several different stocks, you reduce the impact of a loss in any one company.
Moreover, if the stocks you own are from several different industry sectors you
mitigate the impact of any one sector causing a loss.
Exchange Traded Funds (ETFs) offer an excellent way to add diversity to your por
tfolio, as they hold shares of companies based on an index. The index can be for
the whole market, or any segment of the market. When using ETFs, be sure there
is sufficient liquidity (plenty of shares trading) or you will create another un
wanted risk.
Many investors size their stock position based on their tolerance for risk. Dr.
Van K. Tharp performed an experiment on position sizing in his book Trade Your W
ay to Financial Freedom.
Successful investors employ stock market risk management strategies to minimize
their losses. Managing risk in stock market starts with identifying the type of
risk and taking action to mitigate the impact of the risk on your investment por
tfolio. As Dr, Tharp found adjusting the size of your stock position using perce
nt risk or volatility greatly increases your returns. By adjusting the size of y
our position based on the risk you are willing to assume, you lower your potenti
al of a loss and increase your probability of solid gains. Our article on Positi
on Sizing provides further detail on this method to manage stock ownership risk.
Should the price of your stock turn down, wouldn t it be nice if you could exit yo
ur position before the price fell further. Stop loss or trailing stops are tools
used by many investors to close their position should the price fall by a speci
fied amount. Most brokerage firms allow the use of stops using a set number of p
oints below the price or a percent below the price. Trailing stops follow the pr
ice up by an amount you set and then hold that price level on any move down. The
idea of this stock market risk management technique is to leave enough room for
the stock price to fluctuate within its up trend, but be ready to sell should i
t fall below a pre-determined level. Some investors use mental stops as a part o
f the stock market risk management process. Mental stops work well as long as th
ey have the self-discipline to sell when their stop price is hit.
Many people believe equity options are risky investments. It is true that option
s can be risky as they increase your use of leverage. However, professional inve
stors use certain options to reduce the risk of their portfolios. Covered call o
ptions are an excellent way to create some down side protection while increasing
the potential return of your portfolio. Covered calls are suitable for IRA acco
unts, indicating that the authorities consider them a low risk investment strate
gy. Protective put options are another method to lower risk of a portfolio. Simi
lar to insurance, protective puts provide security should your long positions su
ddenly fall in price. When that happens the put option guarantees you will recei
ve the agreed upon price for your stock no matter how far it falls. You can lear
n more by reading articles on covered calls and protective puts that describe th
e features and benefits of these stock market risk management strategies.
The goal of any stock market risk management process is to avoid losing money. F
ortunately, there are several strategies to help you to achieve this important g
oal. The most successful investors employ all the stock market risk management s
trategies, as they recognize how important it is to avoid making a mistake while
investing in the stock market. Do your portfolio a favor and use the available
stock market risk management techniques to your advantage.

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