Risk Management While Investing in the Stock Market

Every investment or trade off in life is a bet on one thing against another. Moreover, risk is inherent in every decision made. Without due diligence and a proper strategy, any action is only as good as a wild gamble. Like in all other facets of life where a reasonable person is expected to deliberate and think through before making a choice one deems best, trading and investing in equity requires one to have a clear idea of what one’s getting into, an executable strategy that accounts for foreseeable developments and an exit plan if things go awry or if a downturn is around the corner.

The stock market provides investors several financial products, such as equities, bonds, derivatives, and mutual funds. Investors can opt for more than one of these financial instruments to diversify their portfolios. Further diversification can be achieved by including financial products offered by different companies belonging to distinct sectors. This protects the overall returns from the investments from market fluctuations and if a specific sector or company moves in an unfavorable way, the other investments in the portfolio can achieve the balance within the investors’ portfolios.

In financial markets there are generally two types of risk; first the Market risk and second the Inflation risk. Market risk results from a possibility of increase or decrease of financial markets. The other risk i.e. the Inflation or the purchasing power risk results from rise and fall of prices of goods and services over time.

The inflation risk is an important consideration in long term investments whereas the market risk is more relevant in the short term. It is the market risk that can be managed and controlled to a certain extent, inflation risk cannot be controlled.

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There are certain strategies that can be employed to mitigate the risk in a stock market. The strategies are as follows:

Follow the trend of the market: This is one of the proven methods to minimize risks in a stock market. The problem is that it is difficult to spot trends in the market and trends change very fast. A market trend may last a single day, a month or a year and again short term trends operate within long term trends.

Portfolio Diversification: Another useful risk management strategy in the stock market is to diversify your risk by investing in a portfolio. In a portfolio you diversify your investment to several companies, sectors and asset classes. There is a probability that while the market value of a certain investment decreases that of the other may increase. Mutual Funds are yet another means to diversify the impact.

Stop Loss: Stop loss or trailing tool is yet another device to check that you don’t lose money should the stock go far a fall. In this strategy the investor has the option of making an exit if a certain stock falls below a certain specified limit. Self-discipline is yet another option employed by some investors to sell when the stock falls below a certain level or when there is a steep fall.

Benefits of risk management include the following:

Increased awareness;
More confidence in objectives and goals because risk is factored into strategy;
Improved operational efficiency through more consistent application of risk processes and control;
Improved workplace safety and security for employees and customers; and
A competitive differentiator in the marketplace.

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Managing Risk as a Trader

As opposed to an investor’s long-term strategy, a trader focuses more on short-term performance. Due to this different approach, risk management as a trader is quite different to that of an investor. It is often tempting to dismiss risk-management practices altogether when trading, however, it is just as important as when investing — and in some ways even more important. Traders often use leverage and trade extremely volatile assets, which are all the more reason to place an emphasis on risk management.

Dealing with Black Swan Events

A Black Swan event is an unpredicted event of extreme significance. There are three rules for classifying such an event: Unpredictability, massive impact and providing explanations in hindsight. Such events include the Great Depression of the 1930s, the Great Recession of 2008, and most recently, the 2020 coronavirus pandemic.