Investment risk management

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Investment risk management

Long-term investors are usually extra conscious about safety; with their life savings often on the line, many of them tend to be relatively risk-averse. One risk everyone wants to avoid is losing too much money on their investments. To deal with this risk, you can employ various investing strategies such as diversification, which we discuss elsewhere on this page. But on a day-to-day practical level, you can also use a number of built-in risk management tools offered by brokers. So let’s see what these tools are and how to use them.

Definition of risk management in self directed investments

Before we dive in, let’s just stop for a moment to define what risk and risk management are. They can mean many different things in various professions and walks of life. In the context of self-directed investments, we at BrokerChooser see risk management meaning all the methods and techniques an individual can use to be aware of or mitigate the unwanted possible negative consequences of any investment activities they are engaged in.

Types of risk

As a long-term equity investor, you’ll face several types of risks that can lead to your investments losing their value.

Market risk: This is perhaps the most common risk of all. It simply means that, for whatever reason, the stock market or the price of a specific stock moves in an unfavorable direction. A poor quarterly result, a botched product release, or just a generally weak economy can all push the price of a stock down, sometimes quite suddenly - so you need to be prepared to spot and handle such price drops.
Liquidity risk: For you to be able to sell a stock that doesn’t perform to your expectations, there needs to be someone else who wants to buy it. In most cases, this shouldn’t be a problem. However, small-cap or otherwise obscure stocks sometimes aren’t liquid enough, meaning you may not be able to immediately sell them at your preferred price, and the price may fall significantly before you find any takers.
Currency risk: This occurs when you invest in foreign stocks, an otherwise smart way to diversify your investments. The relative value of currencies shifts all the time, and if the currency of an asset you hold weakens against yours, you can end up losing money even if the share price otherwise increases. For example, if you’re a European investing in a US stock that rises 10% while the US dollar falls by 20% against the euro, your investment will actually lose more than 10% of its value when expressed in euro terms.
Regulatory/legal risk: The fate of a company and therefore its stock price can be greatly influenced by government policy, regulation or taxes. Unlike a company’s performance or general economic trends, such government interventions are usually harder to predict and can sometimes feel arbitrary - setting them aside from normal market risk.
Credit risk: This is a risk that bond investors are more familiar with; it refers to a situation where the bond issuer (a company or government) defaults on its payments. However, in a general credit crisis, a company you invest in - or even your broker - can also go bankrupt.

Assessing your risk appetite

Everyone wants to lower risk if possible, but there can be great differences among investors on how much risk they are willing to tolerate. So where are you on this scale? Some of this can be down to your general personality traits, such as how disciplined you are or whether you are aware of your emotional biases. But there are also some hard factors worth taking into account when sizing up investment opportunities.

Time horizon: The longer you plan to hold an asset, the more risks you can afford, as you can reasonably expect that occasional price drops will be followed by periods of growth.
Income stability: If you hold a well-paying, steady job, you should be able to take on more risk than those who freelance or work in areas with poor job security.
Liquidity needs: Having a cash reserve that is sufficient to cover your planned big-ticket expenditures - like home renovation or a new car - will allow you to take more risk with your investments, as you don’t need to worry about having to tap into your stock investments at just the wrong moment.

Brokerage tools to manage market risk

In the next chapters, we’ll focus on tools that can help you tackle market risk - mainly because it’s the most common type of risk. Some of these tools, like price alerts or news feeds, are for those who prefer a hands-on approach and closely follow the market for clues to make their next move. Others, such as stop-loss orders, are for those who need an ever-present safety net. And then there are asset types - mutual funds in particular - that come with built-in risk management mechanisms, overseen by seasoned professionals. So let’s see these tools one by one, including tips on which brokers offer them.

Price alerts

Price alerts allow you to get notified - on your phone, your web/desktop trading platform or in your inbox - when the price of a stock hits a specific level. As a risk management tool, price alerts are useful if you want to prevent the price of a stock that you own from falling too much without you noticing. But you can also set price alerts above the current price, to signal a good profit-taking opportunity; or set it for stocks you don’t yet own, so you don’t miss out on a favorable entry price.

Price alerts usually aren’t too difficult to set up - a ‘watchlist’ menu point, a bell icon or a simple right-click on an asset will probably point you in the right direction. As handy as they sound, though, price alerts are not available at all brokers. So check the links below if the broker of your choice offers them.

AJ Bell Youinvest AMP Global ARMO Broker ATFX ActivTrades Admirals (Admiral Markets)Ally Invest Alpaca Trading AvaTrade

News feeds

The price of a stock can be shaped by how that company performs, what its competitors are up to, the general health of the industry it operates in, or prevailing overall stock market sentiment. To stay on top of all these and spot anything that could threaten the value of your investments, you could probably use a good news feed.

Online brokers are all over the place when it comes to news quality; ranging from absolutely nothing to basic third-party news headlines to sophisticated in-house market commentaries and news digests. Decide what you really need based on your time horizon and investment goals; if you’re a long-term investor holding broad-market ETFs, you probably won’t need a Reuters ticker on your smartwatch. With that in mind, check below what news services are available at some well-known brokers.

AJ Bell Youinvest AMP Futures AMP Global ARMO Broker ATFX ActivTrades Admirals (Admiral Markets)Ally Invest Alpaca Trading

Stop-loss orders

Stop-loss orders are basically price alerts taken to the next level. By setting up a stop-loss order, you instruct your broker to automatically sell some or all of your holdings of a stock if its price falls below a certain level. This helps eliminate the risk of a stock you own losing too much of its value simply because you don’t have time to react or aren’t aware of the decline in its price.

You can set a stop-loss order price anywhere you want, depending on your tolerance for risk. However, especially if you’re a long-term investor, it’s a good idea to set your stop-loss order a safe distance away from the current price; so that a temporary small price drop does not trigger the unnecessary sale of an otherwise great stock.

When you buy a stock, you can usually set a stop-loss price on your trading platform’s order panel, just before you press the ‘Buy’ button. Stop-loss orders are available at many brokers; see below if the brokers you’re eyeing are among them.

Mutual funds

Mutual funds invest into a diverse set of stocks; so if you invest in a fund, it’s like investing into all those stocks at the same time. So what does this have to do with risk management? Well, being (indirectly) invested in a diversified portfolio can in itself lower risk, as any losses by a single stock can be offset by gains in other parts of the portfolio.

But mutual funds go one step further - they have a formal risk-management policy that is strictly followed, and which you can study before committing your money. What’s more, funds are actively managed by an actual fund manager and their team of analysts, bringing their professional risk-management expertise to the table.

Not all brokers offer mutual funds for trading, so browse the list below to check fund availability and trading conditions at some popular brokers.

Investment risk management

Definition of risk management in self directed investments

Types of risk

Assessing your risk appetite

Brokerage tools to manage market risk

FAQ

What is the risk of stock investing?

How do you manage risk in stocks?

What does risk management mean in stocks?

What are the 4 categories of risk in finance?

What is the role of asset allocation in risk management for self-directed investors?

What are the key principles of risk management that self-directed investors should consider?

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