Money Matters Wealth Tip #78 – 5 Strategies to Limit Investment Risk

Use these 5 strategies to limit investment risk and keep your wealth growing. While many believe investing can be risky these 5 strategies can limit your risk and protect your investments. Use them to guard against market declines.

Warren Buffet a world famous investor has just two investing rules.

1. Rule #1 Don’t lose money
2. Rule # 2 See rule #1

Why develop risk strategies?

In the investing world there is a strategy to cut your loses short and let your gains run. How do you do that? The 5 strategies to limit investment risk discussed below will give you a few strategies to begin to develop your investing skill. Yes, I did say skill.

The chart below outlines for you the gain needed to make back what you may have lost on a trade.

5 Strategies to Limit Investment Risk

1. Position Sizing

What exactly is position sizing? The simple answer is you limit your investment in any one investment. As an example your investment fund is $50,000. Investing all $50,000 in one position is risky. What happens if the price is cut in half then your $50,000 is only $25,000!

Quite often a company may report bad earning or perhaps a product may be recalled. These event have impact on a stock price. Will all your investment in the one position you have a larger risk than if you had been in several different positions.

This is where position sizing becomes important. If you decide that your risk level is say $5,000 or 10%. This means you are willing to risk up to 10% of your investing fund in any one position. Given that you would end up with 10 positons valued at $5,000 each.

Further limiting your risk by diversifying into different market segments. Do not put all or your portfolio into technology or transportation. Spread it out. Once again diversify.

you 2. Stop loss Orders

What? Many if not all of the trading platforms today will allow you to do this. A stop loss is a predetermined price at which your positon is automatically liquidated.

One of your positions have built up a nice gain or you are willing to loss not more than 20% on a positon. You need to decide this. Here is how this would work. Initial investment $50 price per share. It has grown to $75 a nice gain. As we discussed above you want your gains to run. Here is what you can do. Set a stop loss at $60. What this means is that when the price hits $60 your position is liquidated. You still have a gain and have avoided a loss.

An even better strategy is to set a trailing stop loss. Choosing this option in the trading software would work like this. The stock price is currently $75 and you set the limit at $60 which mean you will be liquidated at $60. If the share price moves to $80 your trailing stop loss would move to $65 increasing your gain. If the price moves down your stop loss remains at $65. This increases your gain therefore letting your gains run. When the stock hits the price you are sold out if it keeps running or stays above the set price your position stays intact.

This can also be done using a percent instead of a fixed price. This protects you against markets that begin to move down.

A word of caution these types of orders are only good for some period of time and you will need to monitor that to make sure the order has not expired.

3. Following the trend

trading against the trend will get you burned. If the trend is up then trade in that direction, If the trend is down then trade in that direction.

The saying “the trend is your friend” simply means to trade in that direction. Markets tend to move in a particular direction so trade accordingly.

If you looked at a chart the chart will tell you how a particular stock is trading. Patterns can be identified. Trade in that pattern. This is how you reduce your risk.

4. Keeping a journal

What? Yes keep a journal of all your trades. But why? This is how you learn from your trades that were successful and unsuccessful.

What information goes into your journal? Anything you want to remember about a trade. This is about avoiding unnecessary risk.

Planning your trade is important. What is your entry point, exit point? What if the trade goes bad? When do you get out, cutting loses short and letting your gains run.

Detail your trade. If you had a gain or a loss the experience of the trade will help you trade better in the future. Learn from your mistakes. Did you let a loss get to large because you let the stock price go below your limit? What limit did you set? Do you trade without emotion?

Keeping a journal helps you trade within your rules. It take the emotion out of the trade.

5. Using options

Most view options as risky but if you know how to use them they are actually less risky than purchasing stocks.

Options can be used as insurance. Here is how that would work. A position you have in stock X has increased by 50%. You think there is some additional upside potential but there is also a possibility that a pullback will occur. To preserve your gains you buy a put. If the stock declines the value of the put goes up. There is a gain on the put option, the stock position remains intact while it is down you have not lost any money because you made it up with the put option. Now you are in positon to take part in the next advance in stock X.

Use these 5 strategies to limit investment risk protecting your wealth. Investing is not gambling. Using these very simple strategies your wealth will be protected. I will warn that you must be vigilant and consistent. Set up your rules and follow them to success.

Continue to educate yourself on investing. A knowledgeable investor is a successful investor!

Let me know in the comments below what you think. What strategies do you use?

Here are other resources for your education:

Stocks and Bonds and Options OH MY!

Options 101

Options 102: Trading Calls  

Options 103: Trading Puts   

If you enjoyed this Money Matters Wealth Tip the series can be found HERE.

Other articles of interest:

10 Easy Steps to Creating a Budget that will put you on the path to Financial Independence

How to get out of Debt: Three popular Plans

4 Payoff Credit Card Debt Strategies

So what are you waiting for? Need help getting started, Grab our FREE budget tools to help you along on this very important journey.

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