Even if you have a really good prediction, you still need to protect yourself from losses. Think of it this way: a weather app that's right 80% of the time still means you'll get caught in the rain 1 out of every 5 days. This article explains some common-sense ideas about managing risk - in plain English.
Common Risk Management Ideas (Explained Simply)
The ideas below are things that traders and investors commonly talk about. Think of this as a glossary with explanations - not a rulebook to follow. Everyone's situation is different, so please research these further and talk to professionals.
Remember: These are common ideas explained for learning. This is NOT telling you what to do. Talk to a financial professional before making any decisions.
1. How Much to Invest (Position Sizing)
The simple version: Don't bet everything on one prediction. The less confident you are, the less you should put at risk.
Think of it like going to a restaurant. If a friend highly recommends a dish (high confidence), you might order a full portion. If they say "I think it's good, but I've only tried it once" (low confidence), you might just get a small appetizer to taste it first.
How confident you are How much you invest
Very confident: Larger amount
Somewhat confident: Medium amount
Not very confident: Smaller amount
Barely confident: Very small amount
The idea: Match your investment size to your confidence level.
Key takeaway: When you're less sure about something, consider investing less in it. This way, if you're wrong, the loss is smaller.
2. Setting a Maximum Loss (Stop Losses)
The simple version: Decide in advance how much you're willing to lose before you get out.
Think of it like setting a budget before going shopping. You might tell yourself "I'll spend up to $100, but no more." A stop loss works the same way - you decide ahead of time "I'll accept losing up to $X, but if it goes past that, I'm out."
Stop Loss = Your Pre-Set Exit Point
Example: You buy something at $100
$95 $100 $108
| | |
EXIT BUY GOAL
if it drops HERE Take profit
to here if it rises
5% loss Entry 8% gain
You decide in advance: "If it drops 5%, I'll exit."
This removes the emotion from the decision.
Why this matters: When prices are falling, it's tempting to think "it'll come back up." Setting a stop loss in advance takes the emotion out of the decision.
3. The Kelly Criterion (Matching Bets to Confidence)
The Kelly Criterion is a math concept from the 1950s. It's often discussed in investing circles, but using it properly is tricky. This is just an explanation of what it is - not a suggestion to use it.
The simple version: There's a math formula that tries to answer the question: "If I'm X% confident, how much should I invest?"
Think of it like a careful friend giving you advice. They might say: "You're 75% sure about this? And if you're right you'll gain $150, but if wrong you'll lose $100? Okay, based on those numbers, maybe invest about 30-40% of what you have set aside for risky investments."
The Kelly Idea (No Math Required)
The basic concept:
- More confident + bigger potential win = invest more
- Less confident + smaller potential win = invest less
- Never invest more than you can afford to lose
Most people who use this approach use a "safer"
version - investing only 25-50% of what the
formula suggests, because predictions aren't
perfect and unexpected things happen.
Key takeaway: The idea is to scale how much you invest based on how confident you are and how much you could win vs. lose. Most people err on the side of caution.
4. Don't Put All Your Eggs in One Basket (Diversification)
The simple version: Spread your money across different investments so that if one goes wrong, you don't lose everything.
This is probably the most well-known investing principle. It's like the old saying about eggs and baskets - if you drop the basket, you lose all the eggs. But if you have eggs in several baskets, dropping one isn't a disaster.
All Eggs in One Basket (Risky)
Prediction A: 100% of your money
If it's wrong: You lose everything
Eggs in Multiple Baskets (Safer)
Prediction A: 30%
Prediction B: 25%
Prediction C: 25%
Prediction D: 20%
If one is wrong: You still have the others
Key takeaway: Spreading your investments around means no single bad prediction can wipe you out.
5. Potential Gain vs. Potential Loss (Risk-Reward Ratio)
The simple version: Before you invest, compare how much you could lose to how much you could gain.
Think of it like evaluating a job opportunity. If you have to commute 2 hours each way (the "cost") but the salary increase is only $1,000/year (the "gain"), that's a bad deal. But if the same commute comes with a $50,000 raise, it might be worth it.
Risk vs. Reward Examples
Example 1: Risk $100 to possibly gain $100
This is "1 to 1" - you need to be right more than
half the time to come out ahead.
Example 2: Risk $100 to possibly gain $300
This is "1 to 3" - even if you're wrong 2 out of
3 times, you could still break even.
Why this matters: If your potential gain is much
larger than your potential loss, you don't need
to be right as often to do well overall.
Key takeaway: Look for situations where what you could gain is significantly more than what you could lose.
6. Managing Losses From Your Peak (Drawdown)
The simple version: A "drawdown" is how much your investment has dropped from its highest point. The bigger the drop, the harder it is to recover.
Here's a surprising fact that trips up many people: if you lose 50%, you need to gain 100% (double your money) just to get back to where you started. This is why protecting against big losses is so important.
The Math of Recovering From Losses
If you lose 10%: You need to gain 11% to recover
If you lose 20%: You need to gain 25% to recover
If you lose 30%: You need to gain 43% to recover
If you lose 50%: You need to gain 100% to recover
If you lose 75%: You need to gain 300% to recover
Notice how it gets much harder to recover as
losses get bigger. That's why avoiding big
losses matters so much.
Key takeaway: Small losses are easy to recover from. Big losses are very hard to recover from. That's why many investors focus on limiting the worst-case scenario.