CHAPTER 29
Risk Management
Before investing in stocks, you need to reduce the risk as much as possible. There are two types of risks, which are:
1. Systematic risk
2. Unsystematic risk
Systematic Risk
Systematic risk means risk that affects the entire stock market. The recession, interest rates, wars, the 2008 financial crisis, and terrorist attacks are examples of events that affect all stocks. To mitigate this risk, your position needs to be hedged. You can buy puts to mitigate downside risks. This is like buying insurance with a finite duration; after the expiration date, you need to buy again. Buying puts is an expensive process because you cannot predict when systematic risk events will happen.
Unsystematic Risk
This is company-specific or industry-specific risk. You can avoid unsystematic risk by diversifying your portfolio. There is no way you can reduce systematic risk because it is related to outside events. However, you can minimize common investor mistakes and thereby minimize your portfolio risk. The following tips can minimize portfolio risks and increase investment return:
1. Don’t use margin accounts.
2. Maintain sufficient diversification.
3. Stay away from the herd mentality.
4. Avoid day trading.
5. Use a research-based investment approach.
No Margin
Margin means borrowing money from a broker to buy shares. For example, if you have $100,000 in your account, you can borrow up to another $100,000 from a broker and then buy shares worth up to $200,000. Different ...
