One of my YouTube followers asked me about risk management. I wanted to clarify things not just for him, but for everyone who reads this. I also plan to make a video on this topic to share on my YouTube channel. Lets start!
I consider three layers in risk management in this context:
- Managing risk through the financial instruments themselves, primarily using stop-loss mechanisms.
- Managing the risk of a financial instrument in relation to the overall portfolio.
- Managing the total risk of the portfolio.
I won’t discuss stop-loss orders in detail, as I assume you already know how to use them—it’s a simple and basic tool.
Let’s focus on managing the risk of a financial instrument relative to the portfolio.
Managing the Risk of a Financial Instrument Relative to the Portfolio
Assume we have 100 units of capital and want to buy a stock with a 5% inherent risk. Also, assume we cannot alter this 5% risk. In this situation, we can reduce the impact of this 5% risk on our portfolio. How do we do that?
If we invest all our capital (100 units) into this stock, we will face the full 5% risk, equating to a loss of 5 units because we risked all 100 units. Instead, if we only invest 20 units, we are still exposed to the 5% risk, but now it applies only to 20 units. This reduces our risk to 1 unit. Essentially, by reducing the capital allocated to the stock by five times, we decrease the risk to our overall portfolio by five times.
This should feel intuitive: using less money results in smaller potential losses or gains. We are taking advantage of this principle.
However, certain problems arise in specific situations. For example, if we reduce our 5% risk to 1% by investing 20 units instead of 100, the remaining 80 units stay unused. If we take four additional trades of the same type, using the remaining 80 units, we will be fully invested. If all five trades fail, we will lose 5 units in total because each trade had a 1-unit risk, and we failed all five. In this case, we end up with a 5-unit loss, which is the same as if we had taken a single 5-unit risk in one stock.
Diversification with Uncorrelation and Managing Risk According to the Portfolio
Diversification and managing a financial instrument’s risk in relation to the portfolio go hand in hand. To manage risk properly, we must diversify effectively. But how do we do that? This is where correlation comes in.
Correlation refers to the relationship between two assets. For example, if the price of stock A falls and stock B also falls because they are connected, they are said to be correlated.
To diversify effectively, we must find financial instruments with low or no correlation. Otherwise, if one asset falls, others will also fall, creating systemic risk in the portfolio. This would make all trades essentially the same, as though we had taken the entire 5% risk on a single stock.
Now that we’ve placed our stop-loss orders, managed risk in relation to the portfolio, and considered correlation when diversifying, let’s move on to managing the total risk of the portfolio.
Managing the Total Risk of the Portfolio
When we discussed correlation, you may recall the scenario where we took five trades and lost them all, resulting in a 5-unit loss. This happened because we had a 1-unit risk on each trade. Therefore, the total risk of the portfolio is the sum of individual risks multiplied by the probability of failure.
The simplest calculation is to assume we fail every trade. In this case, we don’t need to consider the probability of failure—we simply assume the worst-case scenario. If we take a 1% risk on each trade and open five trades, our maximum risk (if all trades fail) is 5%. If we want to calculate more complex risks, we could factor in the probability of failure, but we won’t go into that here.
I’ve kept things simple to show how easily we can manage risk using this approach. I hope this article has been helpful.
Some Implications of This Type of Risk Management
This strategy forces you to use less money when trading high-volatility financial instruments and more money when trading low-volatility financial instruments. For example, if you have 100 units of money and want to take a maximum of 1% risk on a trade, you should use a maximum of 20 units if you buy a stock with 5% volatility. However, if the stock has 2% volatility, you should use up to 50 units. This limits your ability to allocate funds in a high-volatility environment.
We emphasized that the sum of our individual risks is our total risk. So, while we reduce a 5% risk to 1% in the example above, if we use all our money on trades with the same risk level, our portfolio risk would still be 5% (remember, we assume all trades could fail at once). The key takeaway is that if you want to lower your portfolio risk, you need to reduce the risks in some of the individual trades you take.