Risk Management
Considerations
One question often asked is how much capital should one risk
on each individual position? Using a fundamental asset al approach, one
would diversify across multiple asset classes d on individual timeframes
and risk tolerance. After deciding on an appropriate asset mix, the portfolio
would remain fully invested throughout the determined time period, without
regard to changing market conditions. Using this passive strategy, the
portfolio would be allowed to simply “ride out” the corrections in the market
and hopefully regain any losses during market advances.
For actively managed portfolios, many methods are available
for determining individual position size. These include comprehensive methods
such as the Kelly criterion (or Optimal f) and the Risk of Ruin Formula, or a
simple rule of thumb like not risking more than 2% of the entire portfolio on
any one position. For example, if you have a $250,000 portfolio, no more than
$5,000 should be invested in any one security under the 2% max position size
rule.
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Exchange Traded Funds (ETFs) are another great tool for
investors who wish to actively manage their investment portfolios. ETFs can be
traded like individual securities, however, they contain a basket of securities
which provides diversification within the ETF. When choosing ETFs, due
diligence is required by the investor, since some ETFs are well diversified and
others can be highly concentrated in a few positions. Also, some ETFs carry
other risks such as leverage and tracking error.
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One last consideration on risk is deciding how much of the
portfolio should be actively traded and how much should simply be allocated to
passive, long-term investments. This is why developing a rules-d trading
system and maintaining a trading journal to track your performance are
essential components of active trading or investing. If you are just starting
out, you should only trade the amount of your portfolio that you are willing
and able to lose. Once you gain confidence as a trader and can quantify your
abilities with a bona fide track record, you may begin to manage an
increasingly larger segment of the portfolio.
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One of the most difficult aspects of trading is managing your
emotions and ively critiquing your own trading abilities. If you cannot
consistently outperform a buy and hold strategy, then actively managing a
larger portion of your portfolio is probably not a good idea. If you do not
enjoy trading and cannot separate your emotions from your trading, then it may
make more sense to let a professional manage your investments or invest
passively using mutual funds or ETFs.
Being honest with yourself will also help you develop a
trading strategy that fits your personality. Each individual trader or investor
is different and while one style of trading may be appropriate for one person,
it may not be appropriate for another. A key component to developing a strategy
is that it should be easy for the trader to conceptualize and follow the
trading plan. Most of all, it needs to be enjoyable for the trader and not be
in conflict with his or her core values.
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