Everything you need to know about risk management.

Online Stock Trading Guide

Risk Management

The first and most important thing to realize about risk management is that there is no such thing as no-risk investment. The fact is that even investments such as Guaranteed Investment Certificates (GICs) and National Savings Bonds are inherently associated with some risk. This is a fundamental characteristic of the nature of financial institutions; the risk is the offset to the possibility of profit. If there were any certain investments, everyone would invest in those and the market would fail. I will give a brief outline of a few of the different types of risks to what you might otherwise consider secure investments.

Inflation Risk

This is the risk associated with an increasing rate of inflation. Let's suppose you buy a GIC offering 11% paid annually over five years. On $10,000 that gives you $1,100 a year, and many people make the mistake of believing it's risk-free. What often happens is that if the interest rate increases by only half a percent per year, the actual buying power of your $10,000 at the end of 5 years may actually be only about $7,500 or so. And this is with only moderate increases in the inflation rates, nothing like the unspeakably high interest rates of the 1970s.

Tax Risk

Another risk to consider is the inevitable tax risk, of which every investor should be aware. GICs, to continue with the previous example, are notorious for being heavily taxed. The $7,500 returned on the $10,000 in the previous inflation risk scenario can quickly be reduced even further, especially if you're in a high tax bracket.

Interest Rate Risk

Let's say inflation rises after you purchase your 5-year GIC; this often causes interest rates to rise as well. What happens if you find that in your third year, interest rates have risen to 12 or 13%? You are stuck in your five-year contract at 11%, with a loss.

Stock Market Risk

The risk of the market falling is one of the more obvious ones for most investors, yet when warning signs are provided many still choose to ignore them. Such a situation occurred on Black Monday in 1987; a crash had been warned of by many people; there had been a 5-year bull market and some knew that the prosperity couldn't continue forever. Although you can't completely eliminate the stock market risk, it is possible to minimize it by remaining attentive and thoughtful.

Political Risk

The tax risk is certainly one type of political risk, but here we are referring more to the risk of government agencies somehow undermining an investment by introducing some new project, law or institution. Such things are difficult to predict, but note that newly elected governments are the most likely to introduce new political strategies. The most important thing in minimizing political risk is to stay informed; pay attention to the possible economic ramifications of government decisions.

Sales Risk

This type of risk is often forgotten during the heat of daily trading, but is no less important than any of the other types of risks. It refers to the risk of not being able to sell an asset at the quoted price, and can arise due to any number of reasons. The only way to minimize this type of risk is to know what you are buying and to ensure that there is a market to sell. It's not wise to manage your investments solely by the numbers.

Control Your Emotions

Fear and greed are strong emotions that have no place in managing market risk. If you stay on top of the market's signals, and stick to executing whatever portion of your trading plan applies to the current market trends, you will defeat fear and greed while, at the same time, make the right risk management decisions. Nothing else works. Nothing.

As quoted by Richard Dennis - Co-Founder of the Turtle Traders...

"Study and research into the state-of-the-art in money management will pay enormous dividends."


Next: The Path to Trading Success