Saturday, May 23, 2009

What is risk?

I've written this post because so many people have been burned by the typical, pre-packaged sales pitch of "you should buy and hold for the long term." While this advice makes sense when things are going well, it provides no protection of capital to the investor. Ultimately, the investor's goal is to not lose money. "Buy and hold" is broker speak for "I have no idea how to manage risk" and "I'm too busy trying to gather as many assets as possible so I can charge them 2% of their assets per year in management fees to learn how to manage your risk." The next time you speak to your financial advisor, please ask them about risk. Ask them how your wealth is protected if you buy and held Lehman Brothers, Bear Stearns, AIG, Enron, Chrysler, GM, Linen's and Things, Circuit City, etc.? If they define risk as the volatility of returns, simply say "If I held those stocks to the bottom, I would have no more volatility, therefore I would have no risk right?" After you see your advisor's face pale with fear, eeking out the response, "Well... uh... we would have seen that coming and uh... we would have uh... sold it", then please e-mail me and I would gladly be your advisor to help you define risk. There are great tools and strategies out there that are meant to protect you from catastrophic loss, you just need an advisor who is willing to learn and implement these strategies.

What is Risk?
If you go to a typical university that teaches finance, risk is defined as the volatility of returns. I would argue this is a poor definition of risk and will reason this below. An insurance company or bank has a better definition of risk; the expectancy of loss. I have a more practical and a business perspective of risk; exactly how much do I stand to lose?

Why is the volatility of returns a poor definition of risk?
On a portfolio level, it makes sense to get an idea of volatility or returns. Most people are not willing to take a significant amount of volatility to achieve their returns. This is considered a risk-averse behavior, more appropriately, volatility averse. The S&P 500 and Treasury bills are typical examples used to demonstrate volatility. Treasury bills are considered risk-free if held to maturity (excluding inflation risk). The S&P 500 since 1983 had a 1.15% standard deviation of daily returns. This means there was a 68% likelihood of having the mean return +/- 1.15%.

This does not mean a lot to me. Sure, you can tell me that information, but the mean return over time is the most important information. In terms of risk, what does that mean? It means you will get a return between -1.1% and +1.15% about 68% of the trading days, with the median return around .05% per day. In contrast, a t-bill returns a constant coupon with no volatility. It is a “guaranteed” return when held to maturity.

Drawdown is a concept that is typically used in evaluation hedge funds. It is the peak to valley loss in equity. I would argue this is the most important measure of risk. What is the point of knowing volatility if you could lose all of your money? During the Great Depression, the DOW fell 89% peak to valley. In the current recession the S&P has fallen 56% peak to valley. To return to its former peak, the S&P has to rise more than 100%. It is extremely difficult to overcome this and takes time, and lots of it. What would you pay to have been in cash or short the market during these four bad bear markets?

What do you need to make a profit on a regular securities trade?
When you buy a stock, you need a trend in prices that moves in your favor. The good thing is, prices of stocks tend to trend up over long periods of time. Unfortunately, individual stocks and stocks overall are susceptible to bankruptcy risk where the return on investment goes to zero. No matter how volatile or non-volatile the stock once was, the price remains a firm zero. Managing this risk is as important as anything in investing. Markets are the sum of known available information on a security. Prices rising or falling are indicative of a few people starting to know information pertinent to the value of the security. This happens through adjustment of risk premiums used to value securities or changes in earnings.

What types of trades can I execute that do not need a price trend?
None, except holding bonds to maturity as long as they don't default. There are strategies such as options spreads that require little to no movement in price, however a sideways movement in price is still a price trend. Convergence strategies require the movement of prices toward a relative value (actual or historical). Divergence strategies require movements away from actual or historical values.

What about dividends? Dividends typically do not overcome the effects of price movement. For investors that want stable income, buying and holding well run, low leverage companies is an effective strategy to provide passive income. This is one of the few real “investment” strategies that I know of.

How can you profit on the long and short side of the market?
Trend following allows you to take both sides of the market and takes advantage of long term price trends which are typical of stocks and stock indexes. Trend following can be executed in a number of different methods. Some of the most common methods are price channel breakouts, volatility channel breakouts, and moving average crossovers. Each has strengths and weaknesses but all have the ability to be traded profitably over long periods of time.

Why don’t more people trend follow?
The volatility of trend following returns is high compared to buy and hold and its execution requires active management. This makes it unpalatable to very large asset managers. It also goes against the teachings of finance professors who state that the value of a security is the discounted present value of its cash flows. Finance professors create mathematical models to derive the values of companies, and it works decently 95% of the time. The other 5% of the time, the model fails horribly due to forecasting error. As much as people want to think they are prescient, they are not otherwise they would be extremely wealthy. Finance is in fact more of a sales pitch than it is a science.

Do YOU know what’s going to happen?
No. And I don’t pretend to. Here is what I do know.
1. Prices are the only observable unbiased information
2. Markets trend, sometimes for very long periods of time
3. Markets develop trends slowly allowing traders to position themselves appropriately
4. 5% of the time, the financial models put together by academicians fail, resulting in a dramatic repricing of risk. During these times, prices of securities can change very fast in a very significant way. I want to be along for the ride if this happens.
5. Fundamental information is historic and backward looking. Markets are forward looking and may be pricing in information that is slow to disseminate. This causes price trends that may not make sense to investors until after the information has been collected and distributed by the media and researchers. That does not make the fundamentals as tradable as price.
6. Institutional money has to move slowly into and out of stocks due to their effects on market liquidity. This causes price trends that can last over a long period of time.
7. Reacting to price is the essence of following price trends and by clearly defining risk as what I stand to lose, I can appropriately position myself to make a higher return compared to the risk of a big drawdown.
8. The only thing that matters in investing or trading is price. We are all speculators. Investors just think that they are legitimized because they are using fundamental analysis. What matters most is how to effectively ride long term trends and be nimble enough to change positions along with the trend.

Why should I trend follow?
Trend following is equivalent to hedging your bets. Every few years an event comes along that wipes out a large percentage of global wealth. By following trends you can profit from up and down markets. For example, Lehman Brothers had a great 3 years before 2007 & 2008 came along:

But 2007 came along and the trend changed. A trend following system would have taken advantage of this change sometime in the middle of 2007 and would likely have ridden the stock short to bankruptcy. Events like this happen constantly throughout history. These are the events that consistently provide earnings to trend following traders. Below is a simple reversal trend following system applied to the collapse of Lehman Brothers. The results speak for themselves.

How do you trend follow?
Trend following is the most basic strategy of trading. It requires you to answer a few questions:
1. What should I buy or sell?
2. When should I buy or sell it?
3. How much should I buy or sell?
4. When should I exit my position?

For beginning traders, question number 1 is the most difficult question to answer. There is a vast universe of instruments to trade. For those who want to make a lot of money with a lot of volatility in returns and the potential to lose a lot of money, you should pick stocks that are volatile like small cap stocks. These stocks can see huge moves up and down.
Commodity trading advisors (CTAs) typically trade a diversified basket of futures contracts. This has two advantages; the basket is strictly defined and is almost never changing.
Questions 2 & 4 are typically answered by a set of rules that are constructed by the trader to implement a price channel strategy, moving average crossover, volatility strategy, etc. Typically, these rules are mechanical.
Question 3 is a risk management question that is answered by the design of the system traded. To answer it you must define "how much are you willing to lose if you are wrong?" This could be a simple allocation percentage, fixed fractional percentage, or any other algorithm you desire. This is one of the most important questions to answer.

How complex can a system be?
The system can be as simple or as complex as you want it to be. But beware, I’m reminded of an interview I had with a director of Trading at a CTA firm who had previously worked at a firm in the East Coast. He said he had an alpha development team full of Ph.Ds and no alpha (alpha is excess return). His current firm had few Ph.Ds with similar return profiles.
I currently trade a price channel system and a moving average reversal system. The moving average reversal system is newer and is geared toward equity indexes/ETFs although it can be used for commodities as well. The price channel system is used on a basket of futures.

What are the other strategies or tools that can help you manage risk?

Options and futures can be used to reduce risk. These are common hedging tools used by hedge funds, commodity companies, and mutual funds. However, they need to be used very carefully as they have a lot of leverage embedded in them because they are designed for institutional use. To use them effectively, you still have to answer the same questions as above:

1. What should I trade?
2. When should I use it?
3. How much should I trade?
4. When should I sell it?

To answer these questions, you need to have a framework for defining what risk is. I define it as the distance from a predetermined exit position. If that distance is high, then there is a high level of risk. Through historical research, it is possible to see the likelihood of that risk realizing itself. By purchasing an option contract or simply reducing position size when that historical risk is high, you are able to buy insurance for that risk realization. Over a long period of time, that insurance can protect wealth from big losses.

What are you risking?
There are speculators and there are... speculators. Investors and speculators are the same. Investors are speculating that over a long period of time, their "investment" will have a positive price trend. Speculators are speculating that over a period of time, their "speculative investment" will have a positive price trend. Both need to define what risk is. Defining it as the volatility of returns is lazy. Risk is the dollar amount of money you can potentially lose. For stocks it can be 100%, for bonds it could be 80-100% (see GM and Chrysler bankruptcies). There is no such thing as a risk-less investment. By having a pre-planned strategy, you can position yourself to take risks with attractive payoffs with no emotional judgments that hamper your ability to make a smart investment decision. If your broker can't answer your simple question on risk, then you are risking the wealth that you've worked so hard to accumulate.

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