Risk is the potential financial loss for an investment. It’s an inevitability in trading, as every trade carries some level of it. Despite it being a fundamental part, people often misunderstand risk when they start trading.
Common misconceptions about risk include the belief that risk can be eliminated, the assumption that market risk is the only consideration, reliance on past data to predict future risk, and the failure to recognize that risk varies from trader to trader.
Understanding risk is fundamental to staying in the game. Once you move past these misconceptions, you can better manage your risk and develop more successful trading strategies.
Misconception 1: There Are Ways to Eliminate Risk
A common misunderstanding about risk is that there are ways to eliminate it in trading. There is no single way to neutralize risk, but there are strategies traders can employ to mitigate it.
Diversification
Diversification is one way to reduce risk. There are several different ways traders can diversify their portfolios, including purchasing different asset classes (stocks, bonds, cryptocurrencies, etc.), investing in different industry sectors (retail, technology, pharmaceuticals, etc.), or balancing exposure by geography (international vs. domestic) or company size (small vs. large). By spreading capital across different types of investments, traders can balance their risk and mitigate their exposure to any single investment.
Stop losses
Stop losses are another risk-mitigation strategy, but they are not a foolproof way to eliminate risk. Traders use stop losses to exit positions at a pre-determined price to help keep losses to a minimum. While they can help keep losses manageable and take out some of the emotions like desperation and hope that can cloud judgment, they do not always work as intended. There’s the chance of slippage where a trade is executed at a different price than the order, which usually happens in fast-moving markets. Additionally, prices may hit a stop point, triggering an exit, only to reverse direction after the position has already been closed.
Misconception 2: Market Risk is the Sole Consideration
When evaluating risk, new traders often only consider market risk. Market risk deals with how price fluctuations affect an investment. It is influenced by various factors, such as interest rates, political climate and events, and economic conditions. Before a trader purchases stock in a company, they analyze how various macro factors will influence the stock's price and decide whether purchasing it is a good idea.
What new traders may fail to consider are the other types of risks involved in trading like liquidity risk and operational risk. Liquidity risk is the ability to buy or sell assets at an expected price. If a trader enters a position intending to sell at a specific price but finds demand is limited, they may incur a greater loss than anticipated because they are unable to exit the position at the desired time.
Another type of risk to consider is operational risk, or the risk that the company a trader invests in won’t be able to meet expectations. Investing in a company, especially a startup, with projected growth or promised innovation carries the risk that it may not deliver on those expectations.
Assessing all types of risk together before proceeding with a trade can help traders make more informed decisions and develop a stronger strategy.
Misconception 3: The Past Predicts the Future
Many traders fall victim to the belief that because a strategy or an investment was successful or profitable in the past, the same will hold true in the future. Since not everyone has a crystal ball to see what the future holds, there is always the risk that a trade may not work out as it has in the past. That’s not to say that historical data can’t be useful, because it can. Traders just need to be aware that market conditions can shift without notice and in ways that the past cannot predict.
Likewise, thinking that because an investment has been profitable in the past and continues to make a trader money, there’s a lower risk associated with it. It’s possible for an investment to generate continuous profits over time while still causing traders to lose large amounts of money from time to time. Traders should rely on more than past performance to evaluate risk.
Misconception 4: Risk is the Same for Everyone
No two traders are alike, and so no two traders will have the same risk tolerance. An individual trader’s risk tolerance is essentially how comfortable they are with the possibility of losing money. It is determined by several factors, including capital, age, timeframe, and goals.
New traders often make the mistake of emulating someone else’s risk strategy. Modeling your risk tolerance to someone else’s can be detrimental to your investment strategy and cause you to lose more money than you are comfortable with. Even if all quantifiable factors are the same- capital, age, portfolio size, etc.- someone else may be more at ease losing a greater sum of money than a new trader. All traders need to do what’s best for them and stick to their own risk tolerance level when making investment decisions.
How Understanding Risk Helps
With the amount of unsolicited trading advice available, it’s easy for new traders to misunderstand risk. Risk is fundamental to trading, so it’s crucial to have a comprehensive understanding before entering any position. A trader who fails to properly understand risk may enter a position that is not a good fit and lose more money than anticipated or can handle. Learning more about risk and evaluating personal risk levels will help new traders devise their trading strategy and mitigate their risk exposure.
Sources:
https://sageguardfinancial.com/misunderstandings-about-market-risk-a-closer-look-at-diversification/
https://www.warriortrading.com/market-risk/
