Risk Management strategies focus on identifying, assessing, and mitigating potential risks to protect portfolios from significant losses. Utilize techniques such as diversification, hedging, and stop-loss orders to balance potential returns with risk exposure, enabling more informed and stable decision-making.
Hedging
Offset risk by taking opposing positions or using protective instruments. Used By Hedge funds, institutions, advanced traders.
Instruments:
- Options (e.g. protective puts)
- Futures contracts
- Inverse ETFs
Diversification
Spread investments across different assets to reduce exposure to any single risk. Used by all investor types.
Examples:
- Stocks vs. bonds vs. commodities vs. forex vs. alternatives
- Geographic diversification (US, Europe, Emerging Markets)
- Sector diversification (Tech, Healthcare, Energy)
Rebalancing
Periodically adjust the portfolio asset exposure back to target allocation to control risk drift. Used By: Private investors (especially robo-advisors), wealth managers, fund managers, hedge funds.
Frequency:
- Quarterly, monthly
- Threshold-based (e.g. +/-5%)
Position Sizing
Limit the amount of capital allocated to any single trade or asset. Used by Private traders, professionals, and hedge funds.
Techniques:
- Fixed fractional (e.g. risk 1% of capital per trade)
- Kelly criterion
- Volatility-based sizing
Stop Losses and Take Profits
Pre-define exit levels to automatically limit downside or lock in gains. Used by Active traders, hedge funds, and algorithmic systems.
Types:
- Hard stop-loss (fixed price)
- Trailing stop-loss
- Time-based or volatility-based stops
Value-at-Risk (VaR) and Stress Testing
Quantify how much a portfolio might lose in a worst-case scenario. Hedge funds, institutional investors, and professional investors, but should be used by ALL private investors as well.
Tools:
- Monte Carlo simulations
- Historical and parametric VaR
- What-if scenario analysis (e.g. 2008, 2020 crash modelling)
- High-precision volatile scenarios
Capital Preservation Rules
Implement rules to avoid catastrophic losses and preserve capital. Used by Private investors, funds with drawdown constraints.
Examples:
- Max drawdown limits
- High R-Expectancy
- “Cut risk in half after X% loss” rules
- Trading halts after Y consecutive losing days
Volatility Targeting
Adjust exposure to keep portfolio volatility within a desired range. Used by Quant funds, hedge funds, tactical strategies.
Tactics:
- Reduce exposure during high-volatility periods
- Scale up in stable markets
Behavioural Risk
Reduce emotionally influenced decision-making that leads to taking on more risk and poor outcomes. Applied by most professional investors and trading professionals. Not well understood and difficult to apply in practice, especially by private investors.
Tactics:
- Journaling and analysing trades
- Following automated systems
- Using robo-advisors
Risk Parity
Allocate capital based on risk contribution, not dollar value. Used by Professional asset managers (e.g., Bridgewater).
Mechanism:
- Leverage low-volatility assets (like bonds)
- Equalize risk across all portfolio components