When it comes to investing and trading one of the most important things is risk management. Without proper risk management, you can completely blow up your investment portfolio. Or it can lead you to have inconsistent results. It’s not a great feeling when you break even after years of investment.
In this post, I want to go over some important benefits to risk management and how it helps you get a better return on investment in the long run.
Disclaimer: None of what I’m talking about should be considered as financial advice. It is for entertainment and educational purpose only.
Risk Management Leads to Consistent Wins
No one knows what the stock market will do in the future. However, that doesn’t mean there is no way for you to protect yourself from the downside. When you evaluate the risk and reward of an investment, you’re setting criteria to look for. It filters out companies that you consider risky, which leads to you choosing companies that are less likely to lose your capital.
At the end of the day, risk management requires you to give extra thought to your investments. It helps you identify red flags beforehand so it won’t be a surprise. This leads to you picking more high-quality companies, which gives you a higher chance to make a profit.
It Is Tougher to Climb Back Up
A loss in an investment can be a small hit or a catastrophe depending on your risk management. The more you lose the more difficult it is to get back to where you fell from. To understand this concept, let’s consider a few different examples: recovery after a 20% loss, a 50% loss, and an 80% loss.
risk management breakeven return for 20% loss, 50% loss, and 80% loss
Recover After a 20% Loss
You have $1,000 invested and incurred a loss of 20%. This leaves you with $800 left. To get back to $1,000, you’ll need to make a $200 (25%) profit.
Recover After a 50% Loss
You have $1,000 invested and incurred a loss of 50%. This leaves you with $500 left. To get back to $1,000, you’ll need to make a $500 (100%) profit.
Recover After an 80% Loss
You have $1,000 invested and incurred a loss of 80%. This leaves you with $200 left. To get back to $1,000, you’ll need to make an $800 (400%) profit.
From these examples, you can see that the profit you need to make to get back to break even becomes exponential. With risk management in place, you would have to cut your losses early. The more of your capital you can preserve from a loss the easier it is to bounce back up.
Don’t Be a One Hit Wonder
You can win big, but it doesn’t mean much if you’re losing big too. If you’re netting zero profit in the long run then that is a problem. Without proper risk management situation like such can easily happen.
To be profitable in the long-term, you want to always have more than what you start with. For example, if you started with $1,000 and turned it to $2,000. With risk management in place, you shouldn’t let your capital get below $1,000. Maybe you would lock in your losses when you’re down to $1,500. That way you still have $500 more from where you started. If you were to plot your capital growth over time it should be steadily going up.
Long term steady growth
While nothing is a guarantee when it comes to investing if you apply risk management to keep your losses small and your wins big, you’ll end up profitable in the majority of cases.
I hope this post was helpful to you. If you found this post helpful, share it with others so they can benefit too.
If you’re new to investing and need a guideline to help you start your investment journey you can check out my post on setting yourself up for financial success. I also have a post about beginner mistakes to avoid in the stock market.
To get in touch, follow me on Twitter, leave a comment, or send me an email at steven@brightdevelopers.com.