THE IMPORTANCE OF RISK MANAGEMENT

TEH HOOI LING EDITOR
PULSES JULY 2009

"THE DIFFERENCE between a good trader and a bad trader is risk management," says Victor Sperandeo, a veteran
Wall Street trader with more than 40 years' experience.

Indeed, for reckless traders, events of the past 18 months would have wiped them out completely with a slim chance of any comeback. Typically, in a bull market, investors don't worry too much about risk. But a sudden downturn will drive home the importance of risk management. Unfortunately, that lesson will be forgotten as soon as the good times return.

So perhaps as a constant reminder, an investor should have a checklist on risk placed in a prominent spot on his trading screen. What would be on my checklist? Well, first on the list would be: Don't over-extend yourself by taking on huge loans. Leverage, as we all know, cuts both ways. In a rising market, it boosts your return on equity. In a downmarket, it can bankrupt you. No need to look far for examples of that.

Next, when engaging in speculative trades, risk only the capital you can afford to lose. It is unwise to put one's entire life savings in speculative small-cap stocks or their warrants or even structured products which one may not understand. It absolutely befuddles me that some private bankers would put their clients' entire life savings into structured products alone. Some investors saw their entire portfolios go up in a puff of smoke after the collapse of Lehman Brothers.

Perhaps the private bankers themselves don't understand the risk of these products. Perhaps the collapse of Lehman was totally unforeseeable. Still, putting everything one has into a single investment product is not a good idea.

Also, I always try to remind myself: The lower the market goes, the lower the risk. The higher the market climbs, the higher the risk. This is counter to what our emotions would have us believe. When the market is going down, we are gripped by fear and paralysed into inaction, or worse, panicked into selling. When the market keeps going up, we are motivated by greed to make a quick buck. This reminder is good to have in front of one's trading screen!

According to Mr Sperandeo, nicknamed Trader Vic, only 5 per cent of all rallies go up 40 per cent without a correction. And once a rally goes past 107 days, its risk rises from low to moderate or high. Beyond 242 days, the risk is very high. "Rallies are like humans. Getting into the market now is like buying an 80-year old man. Yes, he can live to 85. But if you buy a 21-year-old, you have better insurance," he said when he was in Singapore recently.

A number of trading rules are also targeted at risk management. Rules like: Use stop-loss orders whenever practical; When in doubt, get out; Be patient, never overtrade; Buy weakness and sell strength; Be just as willing to sell as you are to buy; Never initiate a position in a fast market; Don't trade on the basis of "tips".'

Ultimately, the objective of all these risk management pointers is to PROTECT YOUR CAPITAL. And that should be the heading of your checklist, in bold capital letters!