Why risk management is key!

Thursday, 11th April 2019 13:48 - by Rajan Dhall

With so many innovative financial products available risk management is becoming more and more prevalent in today's world of investing/trading.

There is a school of thought about how much of your available investing pot to invest per trade. 

Let's say you are managing 100k and the maximum drawdown that you are comfortable with is around 25% (25K).

You would then look at the 25k as the risk capital. This would now need to be spread between the investments you would like to make. 

The hard part these days is in the equities markets are companies like Patisserie Valerie, Carillion and Debenhams show that no company is immune from ruin. 

Although the percentages of this occurring are low one has to take this into consideration and it can have massive implications on investment size. 

So a fair amount to invest per share would be in the region of 1000 - 5000 depending on the opportunity. Worst case scenario on the 5k investment would be a total loss of 5% of your total capital and 20% of your risk capital. Having said that a 1k loss would be a 1% loss in total account terms and 4% in risk capital terms, obviously much more conservative.

Drawbacks to such a strategy are obvious, if you invest less you will make less if one of your investments turns good. This is the world of investing I am afraid. Diversity and risk spreading have stood the test of time while over leveraging is the most common cause of failure. 

This does not mean that you cant scale in on a good opportunity. For example: if you managed to buy a companies shares for 100p and the price rises to 110p you would be up 10p per share purchased. 

For argument lets say you bought 10,000 shares. Your PnL is now showing a positive GBP 1000 balance. This money could now be used to scale in more. 

Your initial risk could have been managed by a sell order at 75p which means you would have been risking 25% of your initial 10K investment (2.5K), within your risk parameters. 

Now you scale in more with the extra 1000 and buy more share but only with a 1000 risk limitation. This is a way to use the markets money to leverage and not over-leverage your own cash at the beginning and this time your sell order can be placed higher at 90p so if both positions come back you would sell at a loss of 10p per share in position one and 20p in position 2.

It's safer and although you miss out on some initial profit you could save yourself some pain, in the long run, avoiding ruin.

There are many money management concepts and this is just one, I will continue to post about some other theories as time goes on. 

Kind Regards

Rajan Dhall

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.