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Basics of Stock Market Risk Management

Entry in the stock market is free for everyone. There are no special passes or special classes. Everyone has the same chances, opportunities and trading avenues. But unfortunately the number of losers in the market outnumbers the gainers. This is the naked truth. But some gain such fantastic fortunes and therefore the stock market is the tempting fortress that everyone wishes to conquer. The reason for this anomaly is simple. There are very few investors who make painstaking research and know what risk management is. Others are follow-the-crowd type.  The entry gate as well the exit gate of the stock market is full of risks. Between these two gates is the playing ground of the investors, which again is full of risks.

What is risk management?

Risk management is the process of estimating and assessing the level of risk prevailing in the market taking into consideration its prevailing mood and the trends that it is inclined to show, and then develop strategies of combat to meet its challenges. The exercise is to maximize returns. A number of trading techniques, financial disciplines and models are used for the purpose in view.

The returns on any investment depend on the capacity of the investor to take the risk. Capacity refers to both—intellectual and financial. Higher earnings are possible with higher risks. This is called risk premium.

Some of the common types of risks:

Market Risk: Steep fall or abrupt rise in the financial markets

Inflation Risk: The ever increasing prices of goods, with no possibility of their check. For example the purchasing power of Rs.20000/-invested today may be 10 grams of gold. Suppose  the gold prices rise steeply in one year and touch the level of Rs.30, 000/- and the purchasing power of Rs.20000/-invested including dividend or interest, let us assume comes to Rs.21,000/- For this amount, you are able to buy just 7 grams of gold. Inflation has robbed you of 3 grams of gold.

While constructing a portfolio, a professional trader takes into consideration the risk elements first along with the return elements. These need to go in tandem. These issues are elaborated further:

  • Decide precisely how much one is willing to lose (done in consultation with the investors, for the investment perspectives of each client is different.)
  • Whether the stock is adequately liquid, with easy options to buy or sell.
  • Cut-loss levels are fixed in advance. Usually it doesn’t exceed 10% of the capital.
  • Take-profits level is also determined at the time of buying the stock.
  • Buy the stock at the price-level approved by the investor.
  • Diversify the stocks in different segments of the economy; but do not diversify for the sake of diversification. Two good companies may be in the same segment.
  • Have a close look at the entire portfolio if it is reaches the brink of the overall stop-loss level. This is, however, not to advise to close the entire portfolio forthwith. Temporary setbacks in the economy of the country may happen due to various reasons. Keep a close watch and act appropriately.
  • Remember losses are okay, they are normal part of the business, but do not get wiped out from the market by not managing the risk well and well in time. Managing the risk ably makes you a good trader. Before entering, mark the exit point well. In the commotion of the market swings, forget not the location of the exit. You are the security guard for both the entry and exit points. At no stage a trader should allow   emotions take over analytical reasoning.

Dear trader, wish you happy trades. On your investing ingenuity, the fate of many investors depends, who are willing to trust you!

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3 Responses

  1. Gururaj,

    The syllabus of stock exchange is vast and it is more of practical application of the theory. I suggest you to get in touch with your banker, who generally have specialized staff related to this business, or a reputed broker in your area. Begin with a small capital and do some dummy trading. (do trading on paper without actually investing money–this will help you to identify your mistakes)

    Best of luck Gururaj, be careful!

  2. Very well written Chandrakant sir. I just want to know which is the best source of understanding everything about stocks. Thanks a lot.