Risk Management: Protecting Your Capital
Learn essential risk management techniques to protect your capital and optimize your investment returns in any market condition.
Capital Preservation Through Risk Management
Successful investing is not just about maximizing returns—it’s about managing risk. This comprehensive guide covers essential risk management techniques every investor should master.
Types of Investment Risk
Market Risk
The risk of losses due to overall market movements. Cannot be diversified away.
Credit Risk
Risk that a borrower will default on their obligations.
Liquidity Risk
Risk of not being able to sell an investment quickly at a fair price.
Inflation Risk
Risk that inflation will erode purchasing power of returns.
Concentration Risk
Risk from having too much invested in one area.
Risk Management Strategies
Position Sizing
Never risk more than you can afford to lose on any single investment.
- Individual stocks: 2-5% of portfolio
- Sector allocation: Maximum 15-20%
- International exposure: 20-40%
Stop-Loss Orders
Automatically sell positions when they fall below predetermined levels.
- Growth stocks: 7-8% stop-loss
- Value stocks: 15-20% stop-loss
- ETFs: 10-15% stop-loss
Hedging Strategies
- Put options for downside protection
- Inverse ETFs for market hedging
- Currency hedging for international exposure
- Commodity exposure for inflation protection
The Kelly Criterion
Mathematical formula for optimal position sizing:
f = (bp – q) / b
Where: f = fraction to bet, b = odds received, p = probability of winning, q = probability of losing
Psychological Aspects of Risk
- Loss aversion: Losses feel twice as bad as gains feel good
- Overconfidence: Don’t assume you can predict the market
- Recency bias: Recent events don’t predict future results
- Confirmation bias: Seek information that challenges your views