What Is Risk?

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Includes: SPXL, SPXS, TMF, TMV, VXX, XIV
by: Donald Lingerfelt

Summary

What exactly is risk in stock investing? It may not be what you think.

There are a few good methods to reduce risk.

We can also minimize risk through hedging or options.

What is Risk?

The question often arises as to what risk is. Many traders have some idea of what it is but few really understand the concept. It may not be what you think.

In order to define the term and find the distinctions between other closely related words, I went to the primary authority on the subject: Frank Knight, professor of Economics from the University of Chicago. He wrote his book, "Risk, Uncertainty, and Profit" back in 1921. Even today this seems to be the preeminent text on the subject, though others have expanded and modified the ideas since, changing some of the terms, but essentially not changing the ideas he presented. Both the Austrian and Chicago schools of Economic thought based their understanding of risk from this book.

Dr. Knight differentiated risk from uncertainty by saying that "risk" is that possibility of losing money in an investment or activity that is discovered by statistical or a priori means. One can determine the risk by calculating the "odds" of losing all or a portion of an investment. A good example would be a throw of dice. The probability of throwing a 6 is one in six exactly. "Uncertainty" is that probability of loss (or gain) because of events or reason of things that cannot be seen in advance. An example would be political upheaval or an act of God.

"Risk" can be allowed for, while "uncertainty" can only be taken into account by human judgment based on intuition and experience. In stock market speculation, if we know that a particular stock issue fluctuates +/- 2% and we buy this stock, we know we will at some time lose this amount of money on it (from an intermediate high). It is the risk we take. I personally have trouble with this definition as in this case there is not a risk of losing 2% or so, it is a certainty. However, this is the idea.

The uncertainty involved in this example is that we may lose much more than the 2% if some unforeseen event happens. If the mood of the market should turn bearish, then chances are that your stock issue will decline much more than the 2%. A stock could lose 50% if it tends to move with the market in general, even though by fundamental analysis the stock is accurately priced. Bear markets occur most often unexpectedly. They begin from rational fundamental reasons but cannot be timed very well by anyone consistently. If they could, then they would begin sooner as those who knew when they would start would run for the door sooner. Of course one takes into account the time frame when taking risk. The longer the potential time involved, the greater the chances of recovering from a decline.

An event like an explosion, hurricane, or an invasion by an aggressor nation could start a move to the downside in the market in general or at least in those sectors that would be affected by the event. These types of things no one can know in advance. The degree of effect on the market or a stock then must be ascertained by the market participants, using their judgment of the eventual damage the event will have. Even the smartest market participants will often err in this judgment, but they will adapt to the changing environment as it unfolds.

During the 1940's, economist Ludwig von Mises developed the ideas of risk by defining Class and Case Probability. He worked with his brother, Richard, in developing these ideas. Richard was one of the engineers who developed the formulas used today in Aeronautics for risk in that field. A class probability example is the probability of future events based on what happens to other, similar situations by historical analysis. If a stock is in the railroad sector, and all rail stocks decline when a particular event happens, then that stock will probably decline.

Case probability is like uncertainty: there is no way to tell what will happen in case of a particular situation because of the uniqueness of that situation, therefore, there is no possible way to predict an event that will affect the price of a stock issue. There is just not enough history to make any assumptions about it. At this point, the judgment of the individual entrepreneur comes in (all stock speculators are entrepreneurs in this sense). George A. Selgin discussed the differences within the Austrian school in his essay, Praxeology and Understanding: An Analysis of the Controversy in Austrian Economics.

More recently the terms being used for risk are systematic and unsystematic. "Systematic" is the same as "risk," and "unsystematic" is "uncertainty." Interestingly, both types of risk can be either positive or negative, source of profit or loss. These have been further divided into subdivisions as to cause, like risk from government interference, risk from nature, risk from market trend change, etc.

Market trend is an interesting concept. Many traders observe that the market moves in a "random walk," which is absurd. Every participant in the market has the goal of making a profit. Each one is using his or her judgment in the best way possible to achieve that goal. Regardless of the current direction the general market is taking, it is always heading toward the perceived "true" valuation of the market. The "true valuation" is a constantly moving target, based on the collective opinions of very smart participants who are desperately trying to profit in the same venue, but their opinions are also constantly evolving, just not at the same time. The market is always heading toward equilibrium, but it just never gets there. When it comes close, the trend moves sideways but this rarely lasts very long. When the market in general or a stock changes direction, it is always rational, though few may know the underlying reason for the change in trend. Fundamentalists seek to know why and will dig until they find it. Technicians don't care why, they just adapt as soon as they recognize the change has taken place. Other risks include new technology, earnings reports, unexpected economic numbers, and mergers to name but a few.

How to deal with Risk

There are several ways to reduce risk of both kinds. The most basic is to determine criteria for stock selection. While there are many sets of criteria developed by experienced analysts over the years, all of them are only starting points. Several of the better ones are Piatroski, CAN-SLIM, NNWC, and Mark Boucher's set. Criteria include P/E ratios, P/S ratios, average daily volume, sector membership in one that has a high relative strength, a stock that has high relative strength, etc. The choice is very individualistic. From selecting the stock, timing is next in importance. Everyone times their purchases and sales, even those that adamantly deny it. Reading the chart is my method, and I believe that is second to none. Based on my studies, blindly buying any set of recommendations from any system is always bad. After receiving a set of stock recommendations from your system, pick those that show proper chart patterns before you buy one. Just because it is on the list does not make it an ideal investment. Every system chooses stocks that will not perform, so be careful which ones you choose.

Reading and study for the purpose of learning about trading stock and expanding your knowledge about economics and current events is another way of honing your skills in the market. The better, more rounded a person you are, the better you will be at predicting how others will react to events or what may be the realistic value of a stock. Stock speculation is predicting the future using judgment and skill, and the better the speculator is at judging what should happen, the higher the profit. Knowing who to listen to and learn from is also important. Find someone who is already successful and ask questions.

The way to account for case (unsystematic) risk is by buying options (puts) if you are very unsure, or place stops (or both). Options are a form of insurance to stock traders against adverse price moves. A stop will restrict a loss, and the put will (at a cost) prevent any negative event from devastating your account.

Hedging your investments is another way of reducing risk. Hedge is another investment that works counter to your first investment, but is more or less independent of the first. If the first one declines, the second should rally. One can find these pairs in different sectors or by matching a position in VIX (VXX or XIV), or a T-Bond ETF (TMF or TMV), or with a market index (SPXL or SPXS) position. There are books and articles that can inform one of potential matches.

Mixing long term, low volatility stocks or bonds with some higher volatility stocks or ETFs is also a good way to diversify. Diversification is the way Dr. Knight recommended that we reduce risk. He referred to it as "consolidation." Diversifying between sectors and industries is a good way to achieve this as well. Most books on investing and portfolio building use this method. In my opinion diversifying too much can work counter to your goals. One can over-diversify out of profit potential. I recommend no more than ten vehicles but more than four.

Finally, money management is an essential skill to practice. When to buy and sell is only part of the picture. How to buy (if one should build a position slowly) or slowly liquidate one (or not) might be proper in some situations. Using chart patterns to determine when to do these things is important to reduce risk. How to proportion between investments is critical. The number of different stocks to buy is important.

Conclusion

Risk is a lot more involved than one might at first expect. To say that a particular investment is "risky" does not tell us much. We must use our judgment to estimate just how risky an investment may be and use the necessary precautions to prohibit an unacceptable loss. Loss is inevitable occasionally for everyone, but it is how we react to it that makes the difference. By stock selection and money management we can change a very negative event to one that is just a normal matter of course. Risk limitation is part of the speculation in the stock market. We are all entrepreneurs for ourselves, and it is up to us to be the best, most successful entrepreneurs we can be. Risk management is primary to this effort.

Disclosure: The author is long SPXS, TMV, TVIX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.