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1 - Context of Risk and Reward Management
------------------------------------------------------Risk management is an important matter, and certainly a developpement axis in Fund Manager. Risk management depends on the
investing strategy type that is pursued. There are two main investing strategy types:
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Buy and Hold strategy
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A passive investment strategy in which an investor buys securities and holds them for a long period regardless of fluctuations in the market.
An common approach is to carefully design the
portfolio composition to optimize its reward and risk over mid and long term.
Risk management concerns:
* Build an all weather portfolio through diversification (decorrelation) of the investments.
* Keep the volatility low, as the volatility is seen as Risk.
* Smooth effects of market fluctuations with
Dollar-Cost Averaging strategyTools can be used in order to optimize the reward and risk at the portfolio level:
Value at Risk,
Efficient Frontier, etc.
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Market Timing strategy
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An active investment or trading strategy. It is the act of moving in and out of a financial market or switching between asset classes based on predictive methods to gauge how the market is going to move. Predictive methods can be technical analysis, economic data, or anything else (insider, crystal ball...).
In this strategy, the investments (or trades) may be opened and closed pragmatically based on the emergence of opportunities or risks. Diversification and volatility at the portfolio level may not be a significant concern. The investor/trader may focus on opportunity and risk at the investment/trade level, while controlling the cumulative risk of all the concurrent investments/trades in order to not exceed a determined threshold.
Risk management concerns:
* Control the risk of loss and the expected reward of an investment/trade
* Control the cumulative risk of loss and cumulative expected reward of total investments/trades
In order to define the risk of loss of an investment/trade, the investor/trader can use a
Stop Loss (SL) level. This is the maximum loss he is willing to tolerate. In case the SL is reached, he will close the investment.
In order to define the expected reward of an investment/trade, the investor/trader can use a
Take Profit (TP) level. This is the expected reward. The investor/trader plans to close the investment/trade when this level will be reached.
Stop loss and target profit levels are best defined with the help of technical analysis. But other methodologies can be used to set these levels.
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Of course, there are many intermediate strategies and a wide array of variations between these two main strategy types.
As an active investor and trader, I'm on the side of the market timing strategy, and I use SL and TP levels for my investments/trades. So I will focus now on how a risk and reward management with SL and TP levels can be useful and can be implemented.