A casual discussion about Risk
Risk is the most important concept for all traders and investors. Virtualhedge Fund defines risk as degrees of uncertainly. Risk is the variable between greed and fear, opportunity or the abyss. Determine the risk you are willing to take than practice risk management.
Risk for professionals is based on numbers, this is the world of the quants or eggheads if you prefer. You can read books from our recommended reading list on standard deviation, which is a measure of volatility of a security. Unless stated volatility is the annual standard deviation of the daily price change of an equity security. Quants also have to factor in beta (the relationship between a stock when compared to it’s index), interest rates, dividends, market impact, execution costs, and settlement dates. Traders plug these numbers into proprietary models to calculate risk reward, fair value, arbitrage trades, etc. This is an incomplete summary of how to calculate risk. Entire books have been written on volatility alone. Anyway you get the picture.
Mike one of our subscribers asked if we could give an easy to understand lesson on risk. To start you must find a risk free security. Risk less is defined by securities issued by the United States Treasury. Therefore, the three-month T-Bill is the risk free rate for a ninety-day duration trade. Why? Treasury securities issued by the United States Treasury, these are debt obligations guaranteed by the full faith and credit of the United States government. This means tax collections maybe used to pay the holders of U S Treasuries, making Treasury bills, notes, and bonds the safest investment vehicles in the world given the relative strength of the U S economy.
If Treasury bills, notes, and bonds are the definition of the risk free rate. Any return greater than that of the benchmark Treasury has a level of risk associated with it. The bigger the spread the greater the risk. Zero uncertainty equals zero risk. Let’s look at risk from a common sense point of view instead of by the numbers.
Let’s look at an equal mix and duration of Treasury securities, S&P index, and a basket of technology stocks. Focusing long-term on risk only; Treasury securities are risk-free; S&P rebalancing and large-capitalization components are manageable risk from a equity viewpoint; but as for your technology holdings is it rags (2000) or riches (1999). So you better be a trader. What is your risk? Calculate your expected rate of return for a given time period. If your Treasury duration averages 10 years, today’s rate would be around 4.90%. The average return for the S&P 500 for a 10-year period is roughly 10%. The average return for your technology basket for 10 years is 60%. As a rule of thumb comparing investments of identical durations the U S Treasury has no risk, S&P 500 has less risk than the technology basket based purely on their rates of return. It’s important to realize we compared apples to oranges. Less risk doesn’t equal optimization, which is the highest rate of return for the least amount of risk.
Think out side the box. Focus on duration. Think of risk in terms of time, the longer the duration the greater possibility more things can and will happen. Risk is uncertainty. Compare a thirty-year Treasury bond to a very volatile technology stock, which you plan to hold for 2 days, which has the most risk? Key here is certainty. Due to duration of the Treasury bond, the 2-day trade in a highly volatile technology stock has less risk. The assumption here is even a risky company will still be around two days from now. Maybe it will be gone in a year but we’ll be long gone by then. On the other hand Treasury securities are only risk free if you hold to maturity. Many have lost money on T-Bonds by having a liquidity problem that forced a sale before maturity. In thirty years you may have a medical emergency, buy a house, need cash, or change your investment allocation. No matter how small the probability there is no guarantee the U S will be the super power of the future. Rome didn’t last 1000 years, a limited nuclear war or the emergence of China as an Economic super power could change the standard of risk free securities (today’s Treasury securities). The further we look into the future the greater the uncertainty. We know what interest rates will be tomorrow but have no visibility where they will be ten years from now or beyond. Just remember September 11, 2001. Did you factor in the attack on America in your risk model? Virtualhedge fund has quant models that didn’t have a clue that anyone would attack the World Trade Towers. The most common event risks are merger and acquisition announcements. Event risks surprise everyone; so don’t feel bad if your risk analysis is wrong from time to time.
The important thing is you use your risk evaluation to manage risk. To evaluate you must know what you own. This allows you to “mark to market” (calculate your paper net worth everyday). Before you trade have a plan and exit strategy. The purpose here is to control your losses. See articles on “ VHF trading rules” and “VHF common trading mistakes”. If the trade is risky keep the position small, use stop-loss orders, and never average down. In the end it’s risk management that’s important. Understanding risk is great but if you don’t execute and pay attention to your investments you’re investment will control you. Bottom line you must trust us for ideas, strategies, and information but it’s important you be your own risk manager.
Remember we have no way of knowing exactly what you own.
Risk for professionals is based on numbers, this is the world of the quants or eggheads if you prefer. You can read books from our recommended reading list on standard deviation, which is a measure of volatility of a security. Unless stated volatility is the annual standard deviation of the daily price change of an equity security. Quants also have to factor in beta (the relationship between a stock when compared to it’s index), interest rates, dividends, market impact, execution costs, and settlement dates. Traders plug these numbers into proprietary models to calculate risk reward, fair value, arbitrage trades, etc. This is an incomplete summary of how to calculate risk. Entire books have been written on volatility alone. Anyway you get the picture.
Mike one of our subscribers asked if we could give an easy to understand lesson on risk. To start you must find a risk free security. Risk less is defined by securities issued by the United States Treasury. Therefore, the three-month T-Bill is the risk free rate for a ninety-day duration trade. Why? Treasury securities issued by the United States Treasury, these are debt obligations guaranteed by the full faith and credit of the United States government. This means tax collections maybe used to pay the holders of U S Treasuries, making Treasury bills, notes, and bonds the safest investment vehicles in the world given the relative strength of the U S economy.
If Treasury bills, notes, and bonds are the definition of the risk free rate. Any return greater than that of the benchmark Treasury has a level of risk associated with it. The bigger the spread the greater the risk. Zero uncertainty equals zero risk. Let’s look at risk from a common sense point of view instead of by the numbers.
Let’s look at an equal mix and duration of Treasury securities, S&P index, and a basket of technology stocks. Focusing long-term on risk only; Treasury securities are risk-free; S&P rebalancing and large-capitalization components are manageable risk from a equity viewpoint; but as for your technology holdings is it rags (2000) or riches (1999). So you better be a trader. What is your risk? Calculate your expected rate of return for a given time period. If your Treasury duration averages 10 years, today’s rate would be around 4.90%. The average return for the S&P 500 for a 10-year period is roughly 10%. The average return for your technology basket for 10 years is 60%. As a rule of thumb comparing investments of identical durations the U S Treasury has no risk, S&P 500 has less risk than the technology basket based purely on their rates of return. It’s important to realize we compared apples to oranges. Less risk doesn’t equal optimization, which is the highest rate of return for the least amount of risk.
Think out side the box. Focus on duration. Think of risk in terms of time, the longer the duration the greater possibility more things can and will happen. Risk is uncertainty. Compare a thirty-year Treasury bond to a very volatile technology stock, which you plan to hold for 2 days, which has the most risk? Key here is certainty. Due to duration of the Treasury bond, the 2-day trade in a highly volatile technology stock has less risk. The assumption here is even a risky company will still be around two days from now. Maybe it will be gone in a year but we’ll be long gone by then. On the other hand Treasury securities are only risk free if you hold to maturity. Many have lost money on T-Bonds by having a liquidity problem that forced a sale before maturity. In thirty years you may have a medical emergency, buy a house, need cash, or change your investment allocation. No matter how small the probability there is no guarantee the U S will be the super power of the future. Rome didn’t last 1000 years, a limited nuclear war or the emergence of China as an Economic super power could change the standard of risk free securities (today’s Treasury securities). The further we look into the future the greater the uncertainty. We know what interest rates will be tomorrow but have no visibility where they will be ten years from now or beyond. Just remember September 11, 2001. Did you factor in the attack on America in your risk model? Virtualhedge fund has quant models that didn’t have a clue that anyone would attack the World Trade Towers. The most common event risks are merger and acquisition announcements. Event risks surprise everyone; so don’t feel bad if your risk analysis is wrong from time to time.
The important thing is you use your risk evaluation to manage risk. To evaluate you must know what you own. This allows you to “mark to market” (calculate your paper net worth everyday). Before you trade have a plan and exit strategy. The purpose here is to control your losses. See articles on “ VHF trading rules” and “VHF common trading mistakes”. If the trade is risky keep the position small, use stop-loss orders, and never average down. In the end it’s risk management that’s important. Understanding risk is great but if you don’t execute and pay attention to your investments you’re investment will control you. Bottom line you must trust us for ideas, strategies, and information but it’s important you be your own risk manager.
Remember we have no way of knowing exactly what you own.
<< Home