When I decided to write about risk management, I thought to myself, how can anyone make writing about risk management exciting ? Afterall, unless you feel the same way as me, it can be extremely boring.
But here's where I actually got thinking. The majority of articles out there today (even within my own website) are tailored towards how to make money in the stock market.
What isn't so common but arguably the most important is how risk management affects your overall performance.
I've given a case study example of why risk management is so important below and the massive success this trader had after focusing on their risk.
We are all drawn to the great and easy routes to success. Who wouldn't want a simple approach to fast track ourselves to success ? This applies to everything in our lives, not just the stock market.
But the truth is in most instances, success isn't a simple and easy process, there are many failures along the way.
So what's this all about ?
Well, you've read countless books, interviews, articles etc. on the importance of a good risk management process. But what does it really mean ?
First off, if you haven't even got a trading plan or trading journal, then you'll need to start with that to gather some of your own statistics.
Now,let's start with the first reason.
1. It Forces Accountability
Yes, we've all been in a situation where a trade or investment gets out of hand and we are down a lot of money. Unfortunately, if we are truthful, we've all been there at least once in our investing life.
Then, the excuses start rolling in like it's not my fault, the markets are rigged bla bla bla. Don't be hard on yourself, you are not alone if you've done this.
When we focus on risk management, it forces us all to take responsibility for our results. At the end of the day, our goal is to make money and consistent returns. Our excuses will get us absolutely no where and worst of all, we won't learn from it.
Let me give you an example.
Let's say, we bought a stock and the stock instantly went against us and stopped us out only to continue in the direction we initially wanted it to go.
This can drive even the most seasoned trader or investor crazy.
Common excuses from this example would be the market is rigged and deliberately triggered my stop. The market makers wanted to fill my stop for their commissions.
You get the idea.
So instead of looking at that investment and concluding the market is rigged etc, why not actually look into your risk management procedures.
Here's some questions you could have asked yourself in this example.
Now, don't get it wrong. There are times when this fast stop out will occur and you followed your rules and there was nothing you could do differently. That's what I call a good loss.
But can you see how actually focusing on your risk management process from the above example could result in a massive change in underlying returns ?
By simply asking ourselves those questions above, our conclusion would change and we would learn much more about what NOT to do in the future.
Instead of concluding the marker makers are out to get me in which we learn absolutely nothing , we learn the stock traded was very illiquid so it could easily be manipulated with small size.
The lesson from this example is don't invest or trade illiquid stocks that can move around quite easy.
*disclaimer: some of you make a great living from trading illiquid stocks, this is just for example purposes only.
When we reduce our mistakes and learn from our losses, our overall performance changes.
Don't just read this and think, yes that's great. Actually take a look at your own results.
If you can look through all your investments/ trades, you might learn something new about your risk management.
And even one new thing learned could be the difference from a losing trader to a winning one.
2. You Learn Your Average Loss Size
Why does this matter ? Well, focusing on your average loss means you know exactly what reward and winning percentage you need to make money in the markets.
If for example you lose $100 on average and make $100 when you are right. To make money in this example, your winning percentage needs to be a minimum 50%.
Shockingly, so many people don't know this information.
If you are constantly fighting basic maths, you will never make a penny. It's that simple. Focusing on risk management enables you to know this information and make the necessary adjustments.
Here is a simple risk/ reward and winning percentage template. It tells you the required win % to breakeven based on your risk/reward.
So once we know our average loss, we know the risk reward needed to breakeven. Knowing this one piece of information can be very powerful.
So many people fight basic math. Math will always win. Unfortunately, I learned this the hard way. If you know all this information, that is great. You are sorted. If not, I encourage you to dig into your risk management process and learn from it.
3. You Learn Your Max Loss Before Self Destructing
When we accumulate a large amount of statistical data about our own results, we can learn a lot about ourselves.
What am I talking about ?
Well, when we focus on our risk management and all our losses over time, we know that there is usually a number that causes us to self destruct.
An example is say we lose $1,000 and this doesn't effect our ability to follow our trading plans, then obviously this isn't our max loss before we self destruct.
If we lose $5k and then start investing or trading wildly after it, we now know that if we ever have a loss of that magnitude again, we need to take a step back and refocus.
Trust me, this is so much easier said than done. Damn our human emotions :)
You can clearly see here that by understanding what our max pain threshold is on a loss, we can make adjustments, in turn improving our underlying performance.
Look over your losses in your journal and see if there are any patterns whereby you notice self destructing behaviour.
The majority of strategies out there are profitable, it's us as humans that mess things up and this one simple trick can make all the difference.
Again, don't mistake simple with easy. When you actually know and hit your max loss, stepping away from the markets is very tough and revenge trading tends to take over.
4. You can set a fixed percentage loss
Okay, if there ever was a holy grail in trading or investing, this is it. In fact, it's probably the number one reason I became profitable.
So what on earth do I mean ?
When you have a large enough amount of information on your own trading/investing, you can look through your losses and figure out an average cut off point.
Now let me be clear, this is different to an average loss amount in some ways.
A case study example
Mark Minervini, a multi millionaire trader who started from a small amount of money realised this after 6 years of losing money.
The result for him were astonishing. He went over his results and realised that if he cut his losses to 10% of the stock price, he'd have transformed himself from a loser to a winning trader.
This was a massive discovery in my own trading too.
How can you do the same ?
Good question, go over all your results and figure out what would happen if you had cut the trades at a particular percentage.
You would have been knocked out of winning trades as I was but it's hard to argue with the power of this overall.
Here's Mark's trading performance having went over his statistics. The list of his top 10 losses before adjusting.
All this information was derived from his book
His compounded return was -12.05% for that year.
Here's the best part. When he decided what would have happened if I cut all trades at 10%, the results changed massively.
Instead of a -12% loss, he would actually come out with 79.89% profit on the year. Just soak that up for a minute. Going over his results and focusing on reducing risks resulted in a monumental transformation.
The average person would see the -12% and think the strategy is rubbish and move on. But can you see the power of this ?
This one thing is what transformed my own trading too. Like I said, if there ever was a holy grail in trading, this is probably it.
When we study ways to improve our investing returns, we always look for the 'best' strategy or the latest hot thing in the markets that is going to get us there.
However so many of us don't dig into our own statistics. Just look at the example of Mark above, if he gave up on his strategy after 6 years of losses without making a simple adjustment, he never would have made millions in the market.
Focus on ways to minimise mistakes and risks and not ways to be right all the time and the transformation will come in your own results.
The last reason (4) was the biggest turning point in my own results. If you are struggling or even have some success, I encourage you all to take a look back over your risk management and see could you make any adjustments.
You might be surprised with the results, I know I was !
Sometimes, it can really be only a simple change that makes all the differences in your performance. For me it was and I'm sure some of you might have an aha moment when you go over your performance this way.
The very best of luck and I wish you all profitable trading.