Understanding the risks

When it comes to investing many amateur investors will focus on the potential reward that’s ahead of them. However, it’s crucial to pay attention to the risks involved. Arguably, you should pay more attention to the risk than the reward. So, giving at least equal attention to risk is crucial.

This is because risk management, also known as money management, is all about preventing financial disaster. It involves measuring and controlling the risk of losses and making the most efficient use of your capital. While the prospect of potential rewards is exciting, it’s important to remember that risk is an inherent aspect of investing. No matter how good your investing system is, losses are bound to happen. Therefore, understanding and managing risk effectively is key. You must accept that losses are a part of investing and, therefore, think about how to manage these inevitable losses.

Amateur investors often rely on the instinct or the advice of others without much thought, while professional traders understand the importance of having a well-defined system and are aware of the associated risks. They always incorporate some form of risk control, which sets them apart from amateurs. Prioritising profit potential without considering risk often leads to underperformance in the long run and maybe one or two disastrous trades where risk was allowed to get out of control.

A simpler way to define risk is to just ask, “How much money am I going to lose?” Technical analysts, who specialise in studying market trends, emphasise this perspective. The actual amount of money lost or potentially lost is referred to as a drawdown. It measures the decline in the value of your trading account from its highest point. Drawdown can also be seen within individual trades, where it represents the decrease in value from entry to exit.

Understanding the significance of drawdown is crucial because losses have a more significant impact than gains. For example, a 50% loss requires a 100% gain just to break even. Risk management aims to minimise potential losses and protect your trading capital. Note that it is much harder to pull your account out of a deep drawdown without being tempted to take even greater risks than the one that took you deep into the drawdown in the first place.

Trading is psychological

Risk in investing not only involves financial losses but also emotional factors. Losing money while being proven wrong can be psychologically distressing. However, a well-designed trading system can help mitigate these risks. Proper exit strategies and a clear understanding of your trading system/edge can prevent significant financial losses and provide the confidence to handle small setbacks.

In summary, investors should prioritise risk management alongside potential rewards. Risk is an inevitable part of investing, and understanding how to measure, control, and mitigate it is essential for long-term success. By incorporating effective risk management strategies into your trading system/edge, you can protect your capital and navigate the challenges of the market more confidently. So, how well do you define risk?