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The 5 Key Tools You Need In Your Risk Management Toolbox for Investing in Stocks and Other Paper Assets

If you have any semblance of financial intelligence, you know the importance of money management

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Summary

  • Key tools for risk management in investing, such as reward-risk ratios, stop loss orders, protective puts, position sizing, and hedging strategies

  • The importance of managing risks rather than avoiding them, and provides examples and explanations of each tool

  • Financial success is not just about making money, but also about managing it effectively with the right tools and knowledge


As rich dad often said, “It’s not how much money a person makes that determines if they’re rich. It’s how much they keep.” And the best way to keep more is to master the art of risk management.

The importance of learning from mistakes

Robert Kiyosaki wrote in Rich Dad, Poor Dad, “In school, we learn that mistakes are bad, and we are punished for making them. Yet, if you look at the way humans are designed to learn, we learn by making mistakes. We learn to walk by falling down. If we never fell down, we would never walk."

Mistakes are important because they teach us how to do better moving forward…how to survive. Mistakes are forgivable, and we all make them. But what separates winners from losers is whether they learn from their mistakes and make changes to avoid them again in the future. Losers always make the same mistakes over and over again. Winners create strategies to minimize the same mistakes in the future.

In the financial realm, mistakes can be costly. So, you want to avoid making them as much as possible and if you do make a mistake, you want to minimize the risk of making that same mistake in the future. Andy Tanner talks about building your Risk Management Toolbox, so you can protect yourself from unnecessary pitfalls. As he always says, “It's not about avoiding risks; it's about managing them.”

Let's unpack some key tools every investor should have in their financial toolbox.

Risk Management Tool #1: Reward Risk Ratios

When it comes to money, what you don’t lose is almost as important as what you make.

Reward Risk Ratios give investors a clear picture of this balance, illustrating how much one stands to gain for every dollar risked. With Reward Risk Ratios, a higher ratio suggests you could reap more rewards compared to the risks you're taking.

Consider a stock priced at $100. Your analysis indicates it could climb to $120, but it could also drop to $90. The potential upside ($20) is double the potential downside ($10). This 2:1 reward-to-risk ratio means you stand to gain more than you could lose, making the investment attractive.

Andy Tanner often illustrates this with a tale of his early basketball days. Shooting a basket from a risky position might offer high rewards, but if he missed, the opposing team could easily score. He had to weigh the potential point gain against the risk of the opposing team taking the ball. Likewise, in the financial game, understanding when the reward outweighs the risk can lead to better decision-making.

Only you can define what your Risk Reward Ratio is, but you do need to define it—and you need to stick to it. It can be easy to fall into the trap of hoping something will go back up, but hope is not a strategy. Sell if you reach your risk level in a stock or investment, and live to invest another day.

Risk Management Tool #2: Stop Loss Orders

Winners know the importance of an exit strategy. Stop loss orders are your predefined exits in the stock market, automatically triggering a sale when a stock hits a certain price. It's akin to setting boundaries in a business deal, ensuring you cut losses before they grow too significant. By pre-determining your risk threshold via Risk Reward Ratios, you can set your Stop Loss orders and invest with a clearer, calmer mindset.

Just as a rock climber uses a harness, investors use stop loss orders. These tools allow you to predetermine a selling price, ensuring you never lose more than you're willing to. And thanks to today's technology, setting up these orders has never been easier with software platforms making the process seamless.

In most trading platforms, you can now automatically set a Stop Loss order. So, using our example above, if the $100 stock you bought hit your $90 risk threshold, your Stop Loss Order would trigger and the platform would automatically sell your stock. This kind of automation can save your bacon. Imagine if the stock did a free fall to $50 while you were busy doing something else. You’d be out a lot of money, and all because you didn’t utilize your risk management tool of Stop Loss Orders.

Risk Management Tool #3: Protective Puts

Think of protective puts as an insurance policy for your stocks. By purchasing a protective put, you secure the right to sell a stock at a specified price, guarding against sudden market downturns. Just as a businessperson hedges against potential unforeseen events, protective puts allow investors to weather financial storms with confidence.

Mark Cuban famously protected his wealth—nearly $1.4 billion—by purchasing protective puts against his Yahoo stock. When the bubble burst, while many lost fortunes, Cuban's foresight saved him.

As Business Insider shared in an interview with Cuban in 2020, he says the dot com bubble getting ready to burst and made his protective puts moves. “In the '80s, I watched PC companies just blow up, just go straight up and then come straight down,” he said. “I was like, it's going to happen again.”

Javier I. A. Altimari shares a great summary of Cuban’s trade on his LinkedIn post, “Mark Cuban's Genius Trade: Protecting $1.4 Billion”.

  1. For each 100 shares of Yahoo stock, 1 contract of put (strike 85) was bought and 1 contract of call (strike 205) was sold. In total there were 146,000 contracts of calls and 146,000 contracts of puts traded.

  2. The premium of the put exactly offset the premium of the call, thus there was zero cost for this trade (Mark probably had to pay a commission but it is likely the commission cost was rolled into the premium as part of the total deal between Mark and brokers or counterparts).

  3. All options expired in 3 years.

Such option structure is called a Collar and it consists of two legs: buying a downside put and selling an upside call. A costless collar has the premium of the put offsetting the call's exactly so that there is no cost to enter the collar trade.

After Cuban's collar trade was entered, Yahoo's share price reached the stratosphere of $237 in January 2000, making his trade look like a mistake. Then the internet bubble burst, and Yahoo reached the abysmal price of $13 (in late 2002), making his trade a stroke of genius, a great risk management trade without out of pocket costs.

Protective puts work as an insurance policy. You pay a premium for the right to sell your stock at a pre-determined price. If the stock price plummets, you're shielded from major losses.

Andy Tanner often emphasizes the importance of defense in investing. "It's like basketball," he says. "A good defense will often beat a good offense because if they can't score, they can't win."

Risk Management Tool #4: Position Sizing

It's not just what you invest in, but how much you invest. Position sizing is the art of deciding the portion of your portfolio to allocate to a particular investment. Like not investing all the capital of a business into one project, position sizing ensures you don't overexpose yourself to a single asset, allowing room for learning and growth.

To understand position sizing better, let’s take a look at how casinos manage risk by not leaving anything to chance. A casino knows that in games like blackjack, roulette, or craps, they have a slight edge over the player. This edge ensures that over time, the house always wins. But here's the catch: that's only guaranteed over a large number of bets. On any single bet, the casino could lose big.

So, how do casinos manage this risk? They use a concept similar to position sizing.

Imagine a high roller walks into a casino and wants to bet a million dollars on a single roll of the dice. Most casinos would shy away from this, not because they're afraid of the game, but because of the risk associated with a single high-stakes bet. The outcome is too uncertain in just one play.

Instead, casinos manage their risk by setting table limits, ensuring that no single player can place an overly large bet that could potentially harm the casino's financial position. By doing so, they spread the risk across many games and many players. Over a vast number of smaller bets, the odds, or the house edge, play out, and the casino comes out ahead.

Just as an investor uses position sizing to determine how much of their portfolio to allocate to a particular stock, ensuring that no single bad investment can severely damage their financial health, a casino sets table limits to ensure that no single bet can jeopardize its financial standing.

In essence, both position sizing and table limits are about managing risk and ensuring sustainability. It's about playing the long game, understanding that in the realms of investing and gambling, it's not about the quick wins, but about long-term success. As the folks over at Rich Dad would say, "It's not about working for money but letting money work for you." In the casino's case, it's letting the odds work for them.

Position sizing ensures you never stake too much on a single investment. It's the art of deciding how much of your portfolio to allocate to any given position. If a trade goes awry, only a small portion of your portfolio feels the impact.

Andy Tanner, in one of his workshops, demonstrated this by spreading out his chips on the poker table. "If I go all-in and lose, I'm out of the game," he remarked. "But if I manage my chips (or investments), I can play longer and have more opportunities to win."

Risk Management Tool #5: Hedging Strategies

In the tumultuous sea of investing, hedging strategies are your anchor. They involve making investments designed to offset potential losses from other assets. Just as a business might diversify its products to safeguard against market changes, hedging allows investors to mitigate risks and navigate uncertain waters with steadiness.

In the world of investing, hedges act as counterweights. They're tools or strategies used to offset potential losses from other investments. Delta hedging, for instance, involves using options to ensure that small changes in the price of a stock have minimal impact on the overall portfolio.

A practical example is Starbucks stock. Say you've done your homework—fundamental analysis, technical analysis, understanding the company's cash flow—and decide to invest. To safeguard your investment, you might opt for delta hedging. By strategically investing in options that move in the opposite direction of Starbucks, you can offset potential losses.

Andy Tanner often says, "Always remain bigger than your money." By this, he means never let any one position or risk dominate your portfolio. It's about balancing, always ensuring that you're in control.

Put Your Risk Management Tools to Work for You

Risk management is not about avoiding risks but managing them. With tools like Reward Risk Ratios, Stop Loss Orders, Protective Puts, Non-Correlating Assets, Position Sizing, and Hedging Strategies, you can navigate the tumultuous waters of the financial world with more confidence.

Remember, in the words of Robert Kiyosaki, "It's not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for." Equip yourself with knowledge, master the tools of the trade, and you'll be well on your path to financial freedom.

Learn in a risk-free way

If you want to play around with these Risk Management Tools before risking your own money, practice with simulated accounts, called Paper Trading. It provides a sandbox environment to learn without any real-world consequences. Most major trading platforms offer Paper Trading accounts for free. It’s a great way to learn without risking your own money.

Original publish date: August 02, 2023

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