How to diversify and manage risk in trading
Good trading is a balancing act. You want to take enough risk that you can produce big wins, but not to the point of causing substantial losses if you make a mistake or are hit with bad luck.
In theory, your best chance for a huge payout is to put all your money into your best bet and hope you are right. This can be a good idea if you are a gamer or can afford to lose a substantial amount of capital, but if you are trying to build long term wealth this is just not the right way to do it. . Even if the stock you favor turns out to be the winner, the volatility is almost always too great at times if you are too invested in just a few stocks. Even long-term winners like Apple (AAPL) fall 50% or more at various times.
One way to control risk is to use a very short time frame. Many new traders on social media use a trading style of one or two stocks at very short notice and then move on to the next opportunity. Basically what they do is diversify over time. The short period of time serves the same purpose as holding a diversified number of stocks for the longer term. Risk is controlled in a different way, but it also limits returns to some extent.
The amount of capital you work with will also have a major impact on the number of shares you own. It is not possible to be very diversified if you only have a small capital. On the other hand, there are large funds that hold several hundred stocks because there is no other way to put their capital to work.
If the amount of capital you are working with is low, you are faced with the challenge of being too focused. However, if the amount of capital is too large, you may not be sufficiently concentrated. The best returns are often obtained by investors with mid-number accounts that can straddle the close between the two extremes.
William J. O’Neill is the founder of Investor’s Business Daily. Its CAN SLIM method is a position trading approach for growth stocks. He suggested that accounts under $ 20,000 should not hold more than three stocks, depending on the settings. Those between $ 20,000 and $ 200,000 should have four or five, and those up to $ 1 million should have six or seven.
This information may be a bit dated, but it shows how much some investors feel they need to be focused to produce superior returns. O’Neill believed his stock picking methodology and business management would avoid significant losses. He was not a buy and hold investor, and he had very strict loss reduction rules. The idea here is that when you’re right, you have to go big to really profit.
Other famous traders and investors such as Jesse Livermore and George Soros have also preached the value of concentration. They made their fortunes when their big trades worked, but they also suffered dramatic losses when they were on the wrong side of trades. Either way, they have a high tolerance for volatility.
The factors that will determine the number of stocks you own will be the amount of capital you are working with, your tolerance for volatility, your time frames, and your investing or trading style.
I find that I have to constantly push myself to take more important positions. This is my biggest challenge as it sometimes causes uncomfortable levels of volatility. It’s great when you’re right, but the pain is immense when you’re wrong.
In order to take more focused positions, I find that I need to have more rigid money management rules and to trade in a more disciplined manner. As I have often discussed, I use an incremental approach to trading, which allows me to constantly change the size of the position as my risk metrics start to change.
The most important problem here is that we have to be aware that the risk is always present, but we can control it in different ways with the size of the position, the time frames and the money management.
Get an email alert every time I write an article for real money. Click the “+ Follow” next to my signature for this article.