One of my followers asked me about risk management before. After that, I wrote about basic volatility-based risk management (you can review it by clicking here) and made a video. When I shared my video on YouTube, he asked me about how much total risk a portfolio should have. Today, I want to give basic suggestions about the total risk of a portfolio.
The optimal total risk of a portfolio depends on our risk appetite. Some people can handle higher levels of risk better than others. Most people can manage a risk of at most 10-20%. Higher risks than this can create problems. You might want to assume half the risk you think you can handle. For instance, if you think you can handle 10%, try 5%.
It’s also related to how much money we’re using. For example, if we’re using very little capital for trading or investing, we may be more willing to take higher risks because we don’t fear losing small amounts, like $10.
If we purely want to maximize our gains, we could use the Kelly formula. However, Kelly is more effective for individual trades. It requires us to estimate our expected gains accurately. Since financial markets are dynamic, estimating our statistics correctly is challenging. Adapting Kelly to the portfolio level makes it more fragile.
Even if we calculate our maximum risk, we shouldn’t assume that the real drawdown will never exceed this. I would say the real drawdown is likely to be higher than our calculated maximum risk.
For non-fund managers, I believe half or even one-third of the risk you think you can handle would be more appropriate.