This is something that I rarely hear answered or even questioned: What is the risk?
If you’ve ever watched financial television or read any financial publications, it’s usually, “I like this and I’d buy it here“. Or, “I would sell it short because I think it’s going lower“. Statements like that are just fine and there’s nothing wrong with having an opinion – we all have them. But the problem is that it just represents half the trade. The other side, and the more important component is, “At what point is the thesis wrong?”
Risk management is the most important thing we do as market participants. Any idiot can pick a stock that goes up. I mean if you pick enough of them, eventually one of them will work out right? This is no matter who you are or how much experience you might have. It’s not the trades or position that work out in our favor that we need to worry about. It’s the positions that go against us when we’re wrong that demand the most attention. This part often gets forgotten.
I’m not sure exactly why we rarely hear people on the tv talk about risk management. Do they ride their stocks all the way to zero if they’re wrong? At what point do you throw in the towel and call it quits? And how much risk is/was that? There is some responsibility to the reporters and journalists to ask those questions as well. So some of the blame needs to go to the networks and publications to be fair.
Before we enter any position – stock, commodity, currency, bonds, doesn’t matter – we always ask the same question: What is the risk? At what point do we know that we’re wrong? Does that fit our risk parameters? Or is it too much risk for us?
We are all very different as market participants. We all have different goals in the market place. We all have a different risk tolerance and we all have different time horizons. Some of us might be longer-term investors looking years or even decades down the road. Others might be day traders or swing traders. But regardless of our time frames, we all need to manage risk one way or another.
Often times we may miss out on an opportunity because there is way too much risk involved. Quite frankly, if the amount of risk cannot be determined prior to positioning, there is no way that the trade will ever be entered. There’s no, “hey we’re buying it here and we’ll see what happens”. The risk involved always has to be well-defined, otherwise there is no position.
Now remember, not everything you read or see on tv comes from market participants. In fact, more often than not the people talking about something don’t even have a position. If they are an analyst or just a market commentator, they don’t care about risk – they don’t have to. They are just there to express an opinion. They aren’t taking any risk. But as market participants, we take risk every day.
So not only are we concerned about risk, but it is actually the most important thing that we worry about. I have no problem taking small losses. It’s the big losses that I have to worry about. We’re not just blindly jumping off a cliff and hoping for the best.
1) What is the risk?
2) What is the target?
3) Does the ratio between the risk and the target price fit our risk parameters?
All of these must be answered clearly before we can ever press the buy or sell button.
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