Many people nowadays believe that they can do a better job at managing their investment accounts than professionals can and they have opted to sign up for a self-directed trading service rather than paying an advisor to handle their holdings.
Although such a decision can be wise if you know your way around the financial markets, understanding and managing the risks of your portfolio is perhaps more important than increasing your returns or beating a certain benchmark.
So, if you have decided to build an investment portfolio by yourself, whether that is for retirement or wealth creation, the following tips can help you manage the systemic and non-systemic risks that your holdings might face along the journey by using tools such as stop-loss orders and position sizing.
Invest In What You Understand
One of the best but often disregarded tips ever given by one of the world’s most successful investors – Warren Buffett – is that lay investors should only put their money on companies and instruments they fully understand.
If you are a professional from the financial services, oil & gas, or aviation industry you’ll probably feel more comfortable in analyzing businesses within those industries compared to tech companies or engineering firms.
By investing in things you understand you may get an edge over other market participants and that could help you in identifying opportunities that others cannot see. In finance jargon, this is known as alpha.
Additionally, in the event of a market downturn, you’ll be able to keep your nerves in check as you would be able to determine if the correction is an unjustified one or if there is enough evidence to support the downtick. That judgment will help you in making more accurate and informed decisions.
Follow The Margin Of Safety Principle
Warren Buffett’s mentor, Benjamin Graham, introduced the concept of “margin of safety” back in 1949 and since then it has become a pinnacle of the value investing methodology.
What this concept states is that after you have valued a certain business, you should assume that you might be wrong on your valuation by at least 25%. Therefore, if the price that the market is giving you is still fairly attractive after taking that 25% cut from your valuation then you should move forward with the investment.
The benefit of following this principle is that you will allow for a margin of error on your estimates that is perfectly possible even for the most seasoned investors.
Use Stop-loss Orders
Stop-loss orders were introduced by brokers as a way to help investors in limiting their losses by defining a price at which they will be willing to sell their securities in case the market turns against them.
That price is known as the stop price and it is important for investors who follow a self-directed approach to know what that price for each of their holdings is so they can set these orders accordingly to prevent huge losses from occurring.
The Importance Of Positioning Sizing
Positioning sizing, also known as asset allocation, is a practice that involves monitoring the percentage that each holding represents in respect to the entire portfolio. Most successful investors understand the importance of limiting the size of their positions to avoid being too exposed to certain areas of the market or to individual stocks that could drag the entire portfolio with them in case things go sideways.
In the same way, you should limit the size of each of the holdings within your portfolio to a manageable figure. One example of this is cryptocurrencies. Even though they offer great upside, their drawdown is also huge sometimes.
Therefore, to avoid a strong drop in your account balance if the entire crypto market goes south you can limit your exposure to those financial assets to say 5% to 10% depending on your risk tolerance.
Managing a portfolio of investments sounds easier than it actually is as investors could, in some cases, ignore the importance of risk management as compared to the well-advertised importance of yield chasing.
In this regard, by following some of the recommendations and tools outlined above, you can increase the odds of producing positive returns on your investments while limiting your losses in case things do go as planned.