Risk Management
Risk vs Reward
Financial risk management is how you play the defensive half of the investment game. The purpose of risk management is to ensure that your investment losses never exceed acceptable boundaries by following disciplined practices including position sizing, diversification, valuation, loss prevention, due diligence, and exit strategies.
The reason risk management is essential - not optional - is because the amount you lose during the tough times determines how much you must make during the good times to meet your financial goals. You must preserve your capital during difficult periods so that your offensive investment strategy has a larger base of capital to grow from when profitable times return. For example, imagine a football team with such an effective defense (risk management strategy) that they never give up a first down to their opponent. This team will be very tough to beat because their offense doesn't have to score many points to win, and they will have most of the game to do it since the defense will spend so little time on the field.
The same is true with investing. Financial risk management controls the investment game. It keeps the line of scrimmage near breakeven, so the offense doesn't have to make up for losses when executing the next play. It preserves capital when the opponent is pounding away at you so that the next touchdown is new profit rather than recovered losses. Investing without risk management is like being a quarterback without a front line to protect you - eventually you will get slaughtered.
In other words, investment risk management is the secret to safe, consistent profits in any market condition. Few investors understand that without a proper risk management plan you are literally one bad investment from the poor house. By managing risks, you can reduce the odds of financial destruction to as close to zero as mathematically possible. If your objective is financial security, then risk management should be your primary focus. Remember, you can't make money when you are busy losing it.
Loss Recovery
It takes an 11% gain to recover a 10% loss. Not a problem.It takes a 25% gain to recover a 20% loss. Harder.
It takes a 43% gain to recover a 30% loss. Problem.
It takes a 67% gain to recover a 40% loss. Big problem.
It takes a 100% gain to recover a 50% loss. Devastating.
It takes a 300% gain to recover a 75% loss. Catastrophic.
Gerry's Rules on Risk!
Rule No. 1: Never Risk Money Rule No. 2: Never Forget Rule #1