The One Reason Why You Need A Risk Management Plan

By Stephen Jeske, on February 22, 2010

Seems these days everyone has an opinion on how to make money in the stock market. Only now it’s not just the stock market, there is options, foreign exchange, commodities and bonds. And it’s no longer just investing or trading. There’s swing trading, position trading, income investing and dividend investing. Yet I’ve barely scratched the surface.

Yes indeed, there are many ways to make money in the markets. What most people don’t talk about, is that it’s even easier to lose money in the markets. Now here’s the real rub. Unlike John Meriwether, the infamous founder of Long Term Capital Management, chances are that you won’t get a second chance, let a lone a third one.

Photo by msjingles via Flickr

I’ll take a guess and say that you’ve got real capital in the game. It’s money you’ve worked hard for and is not easily replaced. I’ll also guess that it’s going to be a tough sell to go back to your spouse and say “Honey, I blew out our account.”

Small details, such as how to prevent losing too much money, are often overlooked in the rush to make the big bucks. After all, saying that you only lost one thousand dollars because of good risk management, doesn’t have a ring to it. Does it?

Good risk management is not about looking good. It’s not about feeling good. The one and only reason to practice risk management is to prevent you from suffering a serious blow to your capital.

Until recently, most people thought that diversification was the same as risk management. Unfortunately, the Great Deleveraging of 2008 proved otherwise. During this period the SPX fell 50%, and everything else crumbled with it. Virtually no asset class was spared from the carnage.

Those investors who did not practice good risk management suffered major damage to their portfolios. The sad part is that it didn’t have to happen. Here is how to prevent another major blow to your portfolio.

Establish a maximum loss for each and every trade or investment you make. When you reach that point, close out the trade. It’s that simple, yet it’s that hard. It’s hard because you have to admit you were wrong (at least in the short term) that your investment idea would be profitable.

Do you want to be right, or do you want to make money? For illustrative purposes, imagine that you had a trailing stop of 10% on each investment. In the spring of 2009 your portfolio would have been down 10% instead of the market’s 50%. Plus you would have a hoard of cash ready to buy stocks at bargain basement prices.

Naturally, you have to decide what loss level your comfortable with. But I think you get the point. Risk management doesn’t have to be complicated to be effective. You don’t need to be a genius, or have some special insight into the workings of the market. You don’t need to be able to predict what the market will do. You simply need to be able to admit that you were wrong about your opinion. That’s it.

If you don’t want to ever suffer a repeat of 2008, you need to practice risk management.

Recommended articles:

• Investing In Commodities
• 5 Ways to Get Comfortable with the Risks Involved in Single Stock Investing
• Your Future Financial Security Depends On You…And Only You
• How Does Forex Trading Work?
• Does Investment Portfolio Diversification Still Work?
• Understanding Investment Risk Profiles
• 21 Financial Lessons Learned From The Economic Events Of 2008-2009

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Stephen Jeske is an independent option trader and founder of themeatballeffect, a complete swing trading option strategy. Learn how to find trades and how to manage them for maximum profit potential. Subscribe by RSS here.

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