The most important rule of investing properly is not to lose the money that you’ve started with! This might seem obvious, but it is amazing how many people’s trading strategies don’t look at ways of managing risks.
There is some form of risk involved in every kind of investment. Risk management means taking action that will significantly reduce the likelihood that you could lose the money you have invested.
One of the first things that you can do to reduce your risk is diversify. You may be familiar with the term “diversification”. When talking about investment, this really means spreading the risk.
If you have all of your money in one stock, you have more possibility of losing it all. Imagine if that one stock unexpectedly goes down. Even before you could sell the shares you own, you may have lost a major portion of your investment.
On the other hand, if you had taken the same amount of money and spread it over four different stocks, it is unlikely that all four shares will fall dramatically at the same time. This is especially true if you make sure that the stocks are in different industries.
So how can you put this idea into practice? By creating a simple first rule in your trading plan that limits the amount of investment capital that you will risk in any one investment.
For example, if you have $10,000 to invest, then you may wish to create a rule whereby you never put more than 10% into any one share. This means that you would not invest any more than $1,000. That way if a particular stock goes bad, the most you can lose is $1,000.
Whether you know it or not, you have just introduced the concept of “money management” into your trading plan. “Money management” means using rules to protect your money regardless of whether the stock market goes up or down. We’ll learn more about money management in the next few chapters but for now we can summarise by repeating our first step: Never put all your eggs in one basket.
In our Tale of Two Traders below, you will meet two traders – Nifty Nev and Mick – and you will see practical examples of how these lessons are applied to their own trading accounts. See how diversifying your risk can be a great way to protect your trading capital.