Risk management is a key aspect to successful investing as it determines the basis of an investors risk appetite versus their expected reward. There are numerous techniques that are used which focused on minimizing loses and avoiding the risk of ruin. The most important concept an investors can absorb is that risk is directly correlated to reward. The greater the risk an investor is willing to assume the higher the potential reward they can receive. As an investor increases the amount of capital they are willing to risk, their potential reward increases. The key to a successful investment strategy is to determine the optimal risk to assume to achieve a specific return.
Risk is considered the probability of financial loss. By purchasing an asset an investors is assuming the possibility that the value of the asset will decline. In many cases, such as the purchase of a car, investors ignore the risk and view the asset as a necessity, where the reduction in value is par for the course. Investment vehicles, on the other hand, incur risk for any asset that is expected to earn a return above the risk free rate of return.
Theoretically, purchasing and owning a US treasury bill, with 3-months to maturity that is backed by the full faith and credit of the United States is risk free. To achieve a return above the risk free rate, an investor assumes risk. There are a number of techniques that investors can use to monitor and control the risk, which is a key component to any investment strategy.
One of the first risk scenarios faced by investors is the size of the trade they should transact when initiating a position. The most important issue related to bet size is to avoid the risk of ruin. Capital markets are generally volatile and determining the optimal bet size can be the difference between generating a successful investment business and failure.
There are a number of strategies that can be used to determine the trade size of an investment, which include a fixed bet or a fixed-fraction bet. In a fixed betting system, the amount of capital remains the same no matter how large the portfolio grows. This strategy is usually on geared to systematic approaches that require a fixed amount to generate successful returns. To accommodate a situation where the portfolio drifts and becomes too large for fixed bet sizes an investor can define a bet size as a fixed fraction of the equity within a portfolio.