Beginner’s Guide Part 11: Risk management and mistakes to avoid:
You have heard this before, “the higher the risk the greater the returns…”
But, what is also true in this phrase is that “The greater the risk, the greater the potential of a loss.”
What are the different kinds of risks that you may face in your money journey and how may you manage these?
Risk management is all about identifying the things that could go wrong in your journey of investing or trading stocks. Once you identify these risks, you then find ways of eliminating them or reducing these risks to acceptable levels.
You have heard this before, “the higher the risk the greater the returns…” But, what is also true in this phrase is that “The greater the risk, the greater the potential of a loss.”
Before we start looking at different types of risks you may face, let’s point out that risk management does not mean that you will not make losses. You may still make losses. But, good risk management can limit the size or magnitude of these losses. Got that?
Some examples of the risks include:
The internet is a good place to learn and find new things or even start investments. Sadly, the reality is that it is also filled with many fake people and scammers. Many of these will come and offer you investments or trades with “very good” returns. You make money for a few days or weeks before you eventually lose everything. Here are a few ways that may help you identify a scam risk:
- High investment returns with little or no risk. You know they say the higher the risk the better the returns. But, a Ponzi or pyramid scheme could offer you very high returns with very little or no risk assumed on your part. In most cases, all you need to do is bring in new members, put in your money and wait until you get your return. Run with your life and wallet.
- Difficulty receiving payments: You are told stories when you want to withdraw money or it takes forever for them to process your payments and often it is because they are waiting for other inventors to put in some money. Do some simple Google searches or see what people are saying on Facebook or Hello Peter. This can save you a lot of money and trouble.
- Secretive and/or complex strategies: My simple rule of thumb is “stay away from anything you do not understand.” If you are a scooter driver, stay away from trucks. If you cannot swim, stay away from the ocean. Stay away from anything you do not understand.
- Unlicensed sellers: This is important, check if the platform is registered and legit. One day I almost fell for tender fraud. Luckily, I had some checks and balances that eventually saved me. I wrote about it here.
- Guaranteed returns: This is where the creators of the fund/scheme promised you a definite return. They tell you that as long as you invest, you will get returns, for example, a guaranteed 6% per day. The truth is that in investment (maybe except for government bonds,) returns are not guaranteed.
- Consistently high performance: We sort of covered this one already. But, remember most investments did not do so well during the Covid-19 pandemic yet some platforms still showed or purported that they were still making high returns. This should make you very sceptical. When you see crazy high returns that are too good to be true, ask more questions before investing.
- Suspicious or vague business model: Stay away from anything you do not understand. Do not convince yourself that the model will make sense as you transact on the platform. If you cannot understand the model after a 5-minute explanation, run with your life.
- The pressure to find new investors: Ponzi schemes survive by continually attracting new investors. Remember, by definition, a Ponzi scheme is one where the founder robs one person to pay another and to eventually keep some of the money to themselves. If you are continually asked or pressured to look for new investors, that should be a sign. Run with your life!
- Credibility through association: Most creators of these schemes will even take from their family and friends. When you look at this you are lured into investing because of the perceived credibility created by this strategy. But, the truth is that these people are not even scared of stealing from their families and friends.
FOMO is the fear of missing out.
There are a lot of people posting their success in markets on social media. Often, they only post when their trades or investments do well or very well. They rarely post when they lose money (Go to Twitter now and show me one person posting their portfolios in this bear market. Almost zero.) This may put pressure on you to invest or start trading because you feel like you are missing out on the good returns. Often, you will do this without proper research.
Dear friend, do not invest or trade based on what someone else has posted or said. Do your research and understand why you are buying or putting up a trade. Does the business have a moat? Are the fundamentals great? What are the technical indicators saying to you? Is it at the right valuation? Does it make sense for you to put money into that asset? These are some of the questions that you should ask before putting your money in. If you are not sure, run with your life.
RISK ON CAPITAL:
Let’s define this as the possibility that you might lose your invested or trading capital if the markets or certain assets do badly. So how do you manage this risk:
- Invest or trade only from available capital. Let’s define available capital as that sum of money that will not make a difference to your finances if you lose it all. In other words, it is the sum of money that you are willing to lose if things turn out badly and you remain financially sound even after you lose this money.
- Therefore, do not invest or trade from your emergency fund, credit card/overdraft or loans. If your trade or investment does not go well, you are left with a problem on your hands. Rather, Create an opportunity fund that you only apply to take advantage of the market.
- If you are trading, decide at what level you want to accept the loss and move on. Set stop losses or price alerts to make you aware if you have reached your gain level or if your asset has lost value to a certain level.
- Lastly, diversify. Do not put all your money into one asset. Spread your risk over a few assets and these assets must not be in the same industry or asset class. For example, do not put all your money in Crypto or keep all your cash in money market accounts. Diversification also requires you to put money into different markets and even different geographies/countries. What do you think happened to someone who had all their investments in Ukraine or Russia when the war broke out?
LACK OF KNOWLEDGE:
One of the biggest risks is trading or investing without knowledge…you know, following the crowd and investing or trading just because others are doing so. This is dangerous and should be avoided at all costs. I spoke about K.I.D.S earlier in this series. You should apply this to everything you do, not just investing or trading. Let me share that with you
Knowledge — Acquire as much information and knowledge before doing anything or placing your money in anything.
Insights — be on the lookout for insights through the news, articles, social media posts, what you hear people say or talk about etc
Depth — become an expert in what you are doing or planning to do by continually learning and also learning from your mistakes
Strategy — Do not do anything without a proper plan. Have a plan and strategy. Have a strategy that works for you and stick to it. At first, you may have to try different strategies until you find one that works for you.
Emotions are a big part of investing or trading. Winning will make you feel great. Losing will make you feel not so great. Sometimes the market signals will confuse you. Sometimes they will excite you. You will go through all sorts of emotions throughout your investing/trading journey. But, as you become more experienced and apply your strategies and risk management techniques, you will realise that any day is just like any other day. In other words, if you are to survive this money journey, apply for your money rationally and leave your emotions behind. It is difficult, but you will get there with practice.
Some additional risk management tips:
- Have a trading/investing plan in place;
- Make sure the size of your trade is controlled;
- Know the right entry and exit points;
- Be patient but do not stay too long after you have taken gains. Take profit when you can;
- Consistency is key. Once you decide on a strategy, stick to it;
- Once you decide your exit point, stick to it;
- Only move if there are changes in the fundamentals of the business or its model;
- Diversify your portfolio:
- Do not put all your eggs in one basket. Invest in different sectors and industries. Not all industries will do well at the same time. This will safeguard your investments in a volatile market. Also, have some offshore investments;
- Set stop losses so that you can limit the number of losses you may incur:
- This can be anything from 5 to 10%. But, you must understand why a particular stock/asset is falling and if there is a chance it will bounce back. If there is a chance that it will bounce back, I would not be worried about a dip of more than 10%..unless I want to use that as an opportunity to buy more of the same asset;
- Once you have a winning formula, stick to it. Do not change a winning formula.
- Learn from your mistakes and use these lessons to refine your strategy and risk management tools.
This is the last chapter of this series. Next week I will provide a list of references (books and articles I have read.)
Have you learned something from this series? Do you want to share any pointers or experiences?
Please leave a comment and remember to share.