Investment Risk Simply Stated

by: Peter F. Way, CFA

You just lost some of your capital.

The definition is that simple. How it came about may not be, but unless you can learn something from that hot end of the matchstick, it may not matter.

What you need to know about any investment's risk is 1) a credible estimate of how likely, and how big, the loss might be -- in comparison to its likely gain. Along with 2) demonstrated evidence of the qualifications and capability of the appraiser. Cabdrivers, barbers, economists, and bartenders, among others, need not apply.

After your loss, what you do about it is what matters.

If the loss is a mark-to-the-market loss, do you formalize it by action, (selling) or do you recommit your investment at its new lower capital cost, by inaction? If a tree falls in the forest . . .?

The capital is still lost at that point, and it's likely nothing can be done to change that reality. But short of fleeing from the investment scene forever, the investment of the remaining capital ought to be the product of a cost-benefit (investment capital vs. likely return) comparison designed to fit your particular needs, desires, and tolerances.

A sale at this point heightens the likelihood of a good, thorough comparison of alternatives. And may produce some income tax advantages.

The risk of forecast-horizon

The principal problem with long-term investING, is the confusion, in the pursuit of its accomplishment, with long-term investMENTS.

In the 1950s and '60s,the post-world-War-II world was a far simpler place, particularly in the US where we had no massive reconstruction to be accomplished, just the "job" (and jobs to be had) in helping much of Europe and other parts of the world to do that task. We were ahead of everyone else and very likely to stay there for a long time.

Five-year plans could be made by business and other operations, and carried out then with little fear of disruption. Investors (and some investment managers) were led to believe it might never end.

But by the turn of this century, it was obvious that it already had ended, thanks to advances in communication and many other technologies, including business management. As a simple example, consider the computerized discounted cash flow cost-benefit assessment of almost-in-time inventories. The corporate 5-year plan became little more than the wish-list espoused by a politician running for office. (Maybe as by an insecure CEO?)

If the subject of an investment could no more tell what it could be earning, or who it might be competing with, in which markets, from what national base, using what prevalent technology, just 3 years out in time, how could a realistic target price be hung on it -- or on any of the many competitors for the investment of the same available discretionary capital?

Long-term investing can no longer be entrusted to long-term speculations, for that is what they really are, not investments.

The uncomfortable reality is that long-term investing now can only be
accomplished by the hard work of repetitive shorter-term investments. Ones that are allowed to live only within a reasonably foreseeable time horizon. Given today's equities markets, that has to be less than a year, in most cases.

HORRORS! Now you're talking about trading, not investing!

No, we are talking about recognizing the essential role that time plays in a real-world investment environment. Speculating about events where the odds of a correct forecast are less than 50-50 means that a bad bet is likely to be made. The way to improve those odds is to shorten the forecast horizon.

That shortening can be overdone. When it gets down to a couple of weeks or just days, even though there is plenty of data experience to measure, the breadth of that odds-bandwith between 49 to 51 and 51 to 49 turns the decision into a "who knows?" No intelligent investor wants to be there, that's just gambler territory. Now we are talking about trading.

The key here goes back to our original prescription for a remedy for risk. The first job now becomes finding a qualified, experienced assessor of the likelihood for a risk event to take place, as well as how big that risk might be. The second job? Getting him to tell you what he really thinks.

Maybe a third job is convincing yourself that, even if he knows, that he is being square with you.

A demonstrated, credible, qualified risks appraisal

Probably we wouldn't have framed the problem this way if we didn't think we have some help to offer. Not a solution, just some help.

We are great believers in motivation. We also believe that intelligent humans will strive to protect what they have that is good, and seek to expand on it where they think it will improve their lot in life. On the investment scene, the best informed players in this very serious game tend to be the best resource-supported ones, and tend to have strong lengths of varied experiences. Because the market-making traders [MMs] use these advantages skillfully, and the "level playing field" is easily confused with the topology of Idaho, they are obscenely-well paid.

Which adds another positive motivation to the mix. They for sure don't want to lose their positions and financial rewards. So they can and do spend adequately to protect what they have from loss due to risk.

What risk? The risk of losing their employers' at-risk capital, required often to complete the volume trades (blocks) that are key to their jobs. So they buy price insurance, hedging, to minimize the odds for, and the exposure to, loss.

Its cost comes out of the price spread possible on each trade, so the MMs make the most intelligent trade-offs they can with what they know. This is intelligent behavior, perhaps at its most precise. Precise because the hedging cost is usually earned by the proprietary trade desk of a competing market-making firm, which has equivalent skills, experience, resources, and information on the same issue. If they demand too high a protection cost for the big-fund originator of the trade order to swallow, the deal fails, at least at present, and neither market-maker gets paid.

But thousands of these trades, each worth over a $million, get done every market day.

Our fun part is that we know how to tell, from what is paid for the protection, and how the hedges are structured, just how far up and how far down both sides of the protection package negotiation figure the fund clients, in the aggregate, are likely to push the price of the underlying issue, or see it pushed.

So intelligent forecasts of this type are being made every market day on hundreds to thousands of stocks and ETFs. Besides collecting their forecasts, we look in subsequent weeks and months, to see how well the actual market prices confirm the MM outlooks. From that, extensive actuarial tables of ODDS and PAYOFFS can be, and are, compiled. Over seven million of them, accumulating day after day.

Every market day there are going to be positions taken in stocks and ETFs where prior forecasts with similar balances between upside and downside price move expectations have resulted in end-of-day sell targets or time-limited closeouts producing profits in 9 out of ten cases, often starting in as many as a hundred or more separate days from the past 5 years for a given stock. With average holding periods of such positions typically taking no more than 8 weeks, six or more repeats of 8% to 12% payoffs tend to produce CAGR results, even after that tenth loss, well above 50% a year.

All with the fore-knowledge of the average maximum price draw-downs (from cost) during each of those prior implied holdings.

That is a game changer. These are realistic and practical definitions of risk. All are comparable with one another investment candidates, through their odds and payoffs potentials. They can be mitigated by well-directed timing of selections. The opportunities exist across hundreds of actively-traded stocks and ETFs, from widely varied types of economic activities. At a scale and in time slices that are rewarding and can be accomplished. The avoidance of time-eating and losing-period stocks can help raise overall portfolio wealth-gaining results.

Is it T.G.T.B.T? (Too good to be true?) Perhaps. Experience tells us that actual market accomplishments are rarely as good as expected. Particularly when many investors are aware of something that might either make them money, or allow an "other side of the trade" a chance to skin 'em.

At least this approach is self-adjusting, with changes coming from some of the best players in the game -- up against other "best players."

Additional Disclosure: The author has an investment interest in the website which, while not yet open to the public, is in conversion from being a delivery medium of information to institutional investors to a new life of providing similar help to do-it-yourself investors. Both brief and extended-time subscriptions for single or multiple issue inquiries should be at quite reasonable and manageable costs for individuals. Announcement of its opening is hoped for in the 4th quarter of this year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.