Three practical ways to manage your risk when investing

Risk-reward ratios

Risk-reward ratios help you understand the level of risk you’ll be able to handle while you hold onto a share. To use a risk-reward ratio, you need to determine your expected return and risk appetite for a particular share - before you buy it.

For example, let’s say you believe a share in your portfolio will return a 20% gain on your initial outlay. There should be an associated level of loss that you’d be prepared to withstand in order to achieve that 20% gain. You might decide that you’re prepared to have the share fall 10% while you wait for it to deliver your 20% return. This means your risk-reward ratio is 2:1.

The ratio is a good planning tool when assessing your portfolio, as it helps you make rational decisions about your shareholdings. If the share falls before it reaches your expected return, hopefully you won’t panic over what to do - because you’ve already decided how low you’re prepared to let the share fall before you sell it.

The level of risk you calculate should be based on the historical trading range of the share. Does the share tend to fluctuate around a particular high or low point and do you feel comfortable that it will remain within that range? You should also consider your own personal risk appetite and how much capital you’d feel comfortable losing.

Remember, if your investment does fall, you’ll often need an excessive recovery in price to regain your initial outlay. However, predetermining a level of risk gives you the opportunity to limit your losses.

Conditional orders

One of the hardest decisions for investors is deciding when to sell a holding. This is especially difficult if there’s a rapid slide in the share price of a company in your portfolio. You might be feeling anxious that your losses will be magnified the longer you hold on to the share. But on the other hand, it’s hard to let go of a share knowing that you’ll miss out on the potential for a rebound. What’s a shareholder to do?

A common tool used by investors to avoid these situations is what’s known as a "stop-loss" or "falling sell" order. This is an order that will automatically place a sell order into the market if your share price falls to a particular “trigger” amount. The trigger amount is whatever you choose based on your risk tolerance and your risk-reward ratio. Determine a price where you would be willing to exit your holding on the downside, and set a stop loss when the price of your share reaches this level. The conditional order allows you to limit any further potential downside.

You can set up conditional orders¹ using your CommSec account for no additional charge. Look for "Conditional Orders" in the Trading menu.¹

It’s important to know that once your stop-loss has been triggered, there’s still the potential for the share price to recover in the time period after you have sold. Although this might make you question whether you sold too soon, it’s a chance to review your beliefs about the particular company and consider whether it might still be a worthwhile part of your portfolio. In this scenario, you should research the business in depth, until you’re confident that you are prepared to re-invest.

Diversification

Diversification can be used as a risk management strategy because it reduces the likelihood that a single event or situation could pose a large threat to your portfolio.

Although buying a larger number of stocks will usually give you greater diversification, it doesn’t guarantee it. It’s important to look at the sector and industry that each of your investments falls under, and choose companies in sectors that are impacted differently by market and economic forces. This reduces the possibility that all the holdings in your portfolio will fall at the same rate, at the same time.

Investors using a diversification strategy should try to find businesses that have the ability to generate earnings growth in different conditions and points in the economic cycle. For example, an insurance company generates earnings differently to a large retail or consumer discretionary company.

In the long term, being diversified appropriately will help your portfolio weather the fluctuations of market cycles and market downturns without suffering a significant loss of value.

Let’s wrap up

• Some simple risk management strategies can give you the framework to manage your portfolio and achieve your investment goals.
• Risk-reward ratios can help you determine what level of risk you’re prepared to take on for any individual investment.
• Conditional orders can be used to automatically place a sell order if your share falls to a particular price, limiting your potential for further loss.
• Diversifying across companies that are affected by different economic conditions means your portfolio is less likely to be wiped out by a single event.