7 Ways Investors Let Risk Hurt Them

by: Peter F. Way, CFA

Summary

All investors know that the game is Risk vs. Return; they want return and fear risk.

Those who have played the game more than once usually have experienced what risk can do.

But they continue to have encounters. Why? How to minimize such experiences?

One answer: Become a risk oncologist.

Risk is like cancer - it has many forms

It has lots of disguises, ways to hide from you until it is ready to strike, painfully, perhaps even fatally.

But Risk can be dealt with, probably better than you do now. Here are some suggestions, and the reasons behind them.

The most common reason investors get hurt by Risk...

... is because they don't get paid enough for accepting it.

That's right. Most investors recognize they are toying with Risk in every investment they make. Few rubes believe there is any "sure thing".

But if the Return is worth the Risk, and the odds are good enough to win sizable payoffs often enough, then Risk gets accepted because it appears likely to be offset by the repeated returns.

Then why does the plan go so bad, so frequently?

Perhaps the Return payoff is badly defined

If due diligence (the check on reliability of one's information sources) is not thorough, the investor may be ingesting bad inputs, either due to the purveyor's own inadequacy or intention on the part of the source(s).

The world is not a perfect place, and human perceptions of it often err. Yogi noted this happens even more when the future is involved.

Future Rewards (Returns) may rely too much on what has happened in the past. Both as to per share Earnings and as to Prices related to them, via past P/Es. It can happen by relying on history instead of contemplating how and why circumstances may have changed the market-moving expectations of future Ps or Es, especially the Ps. Lots of credible researchers are chasing the Es.

Perhaps the odds of winning and losing are amiss

Or are the odd even explicitly being considered? It may simply be assumed that the payoff is going to be delivered. Isn't it tasty! Isn't it compelling! Think of all the things that can be done with those winnings! This is your target, so pull the trigger. "Ya can't hit if ya don't shoot!"

Today's TV marketers teach the Wall St. marketers never to talk about costs - keep the focus on the (for sure) benefit. (Don't even try making the cost a benefit by telling how much it has been reduced by this offer's certain "saving". That may not be persuasive with investments.)

If odds are to be considered, where can they be found? Or do they have to be developed from scratch by extensive data retrieval and analysis? A big job. Has anyone done it? How were the measurement circumstances determined?

Perhaps the Risk is badly defined

Decades of credentialed, professional investment analysts and portfolio managers, as well as budding academic investment professors have been taught that Risk and uncertainty are excusably confused and are to be misperceived. Legions of consultants with only career (not capital) skin in the game flocked to the disguise that "volatility of return is a proxy for Risk".

The fatal, fraudulent flaw in that definition is that investment Risk has only to do with losing, either (or both) capital and time.

Loss of time is every bit as much a loss as loss of capital, because once time is spent, it can't be replaced. Every commitment of capital has a conjoined commitment twin of time accompanying it. In measuring results (CAGR), time is a power-function component, while all the others are "linear" in their relationships. So time is not only a component subject to loss, but its abuse may be more telling than the loss of capital.

A Risk definition has little to do with encountering pleasing surprises.

Return volatility is as good a proxy for opportunity as it is for Risk, because the statistical measure typically used is "standard deviation" of price changes over a time period. The price changes are measured from a calculated trending-over-time mean value, which includes both positive and negative variances from that mean. How often do you hear "volatility" used as a measure of opportunity?

The standard deviation has been tempting to academics (and consultants) for decades, because its apparent "sophistication" is a career-builder and a defense against less-educated competitors. It is a tool to confound regulators, investors and clients. The practice of "normal statistics" provides an appealing base of standardized "expected" normally recurring distributions of variables encountered in human life experiences.

But back in the 1960s, when I attended meetings where these ideas were being propounded at the Center for Research in Securities Prices (CRISP), one of its leading academics politely, and without adequate forcefulness, opined that the voluminous data at hand (over several prior decades) showed that stock prices did not behave in ways compatible with "normal distributions".

He was, in effect, not literally, told to "shut up and sit down before you spoil this program for all the rest of us".

And so the elegant myth of the Capital Asset Pricing Model (CAPM) evolved, employing standard deviation and other "normal statistics" as essentials in its theories. Its marketers have been skillful in perpetuating the deceptions for nearly half a century. Perpetuated despite its essential employment of "normal statistics" measures and inferences that are not supported by prior (or now past) experience.

Currently, after witnessing an adequate history of inadequate advantage in using CAPM, the professional investment community is searching for more productive definitions of Risk.

The challenge is in separating price changes into opposite "threat" and "benefit" camps.

Voluminous multi-year price histories of thousands of securities have been performed looking at calendar-oriented changes, and typically, researchers come to the notion that price changes are random events, perhaps not predictable.

That has led many investment interests to regard "what to invest in" as much more important than "when to do it", since the best "whens" are less predictable than the "whats". Investments-talk is: "Selection is more important than timing".

It may be so until the results are measured from a wealth-building point of view, using compound annual growth rates, expressing the "time value of money". Then, the cost of time may reverse that decision because of time's power influence on "when" the "selection" is being performed.

Perhaps Threats vs. Benefits need realignment

One serious misconception of Risk is that it is properly defined over specific time periods. The implication is that Risk is static during the period. Return volatilities, with their fatal flaws, are often calculated over multiple decades - the longer the period, presumably the more "accurate" the resulting average.

But it should be perfectly apparent from an example of a stock, which, in a fraction of a year, has gained in price by some number of multiples of its recognized and anticipated price and earnings growth. It is likely to be more at risk of a price decline now than it was some months ago. Especially if risk is being taken as evidenced by "standard deviation" with a tendency to "return to the mean".

And even in widely held, heavily researched, carefully watched stocks, such price changes are a frequently observed phenomenon. The markets are commonly "price-noisy".

Prices themselves, and their prior experiences, are an essential part of the evaluation of threats and benefits - far more importantly than are calendar periods.

And even more significantly, expectations of the future are far more telling about what may be coming than headlines of the past. Especially in a game setting like the stock market, where the coming actions of players are influenced by expectations - their own and those of others.

But in one way, the past may still be one of our better guides to Risk - if it is coupled with expectations for future prices rather than assigning simple static averages to past history.

Accept, for a moment, that future price change forecasts may be capable of being made, not as single-point targets, but as ranges of likely possible outcomes within a time horizon credibly capable of being forecast. Such ranges would logically surround the current market price, but not with the necessary symmetric, even balance defined by the standard deviation function.

But since risks, and their perceptions of them by human investors, are likely to occur across an array of threat versus benefit balances, it makes sense that experiences of subsequent price loss might usefully be categorized by that balance, rather than by static calendar periods.

Still, there is a need for some rational limit of time to scope the potential size of worst capital damage to such risk exposure. That can be found in the forecasts' time horizon. (More later.)

When worst-loss experiences are segregated by threat versus benefit balances, a much closer and more useful specification of probable risk is made available on an issue-by-issue and forecast-by-forecast basis.

Perhaps investment "hands" are being overplayed

Expecting success to continue "long term" when it has resulted from shorter-term effects is not realistic. The recognition that Risk is not static means that sooner or later after shorter-term reward benefits, Risk threat is likely to catch up. Investment-talk: "Trees don't grow to the sky".

But where does the sky begin? In California, there are some redwoods...

Any specific investment adventure begins at one point in time and needs a specific definition of success, a target to shoot for. Once the target is accomplished, enthusiasm is high, but further commitment of capital and time needs a review of all the available alternatives at that point. A reappraisal even including continuation of the present satisfaction - but from an appraisal of its present circumstances, not the prior circumstances.

Likewise, anything short of that target success within the practical forecast time horizon also needs a renewed appraisal of the current best alternatives. Time becomes the cost foe in achieving satisfaction. At the commitment's start, then was then. Now at the forecast time horizon, now is now. It is time to start the capital and time adventure all over again, building long-term results from a concatenation of shorter-term ones.

Perhaps the investor is too intent on his/her own present skills

Sometimes, there are resources outside of present knowledge that can be called upon to up the investor's results. Circumstances vary, and in some cases, contracting out the whole task may be the most practical answer. For many less financially fortunate investors, this is an unacceptable approach, for a variety of good reasons.

Where the investor chooses to maintain his/her control over the selection, timing, and emphasis of capital commitments, sources of external information inputs to aid the process are numerous. The pervasive problem is TMI - too much information. The little that is not so readily available makes insights by others with access able to quickly diminish its benefit potential. One wonders if some of the offerings are designed to encourage overreactions by an investing public, so that the vendors might benefit from contra-actions. Due diligence required as a defense?

One approach is to use actions in the derivatives markets as competitively vetted expectations of securities prices in the future. Several advantages present themselves in this approach. What are traded in these markets are contracts with defined rewards under specified outcomes within (or at) the time of the expiration of the contracts. So a forecast horizon is defined, aiding in the management discipline of time invested.

The open, fair, competitive public markets for derivatives sets an easily audited price for the contracts within their conditions, rather than the vague, simple hopes of what might occur - those unbounded hopes that drive the prices of stocks. Comparisons of these contracts are usually between prospects for the underlying equity security's prices, rather than being based on the company's competitive, economic, resource or other corporate circumstances.

The derivative contracts' focusing directly on equity securities prices makes their implications of equity investment rewards much more directly comparable between securities than discussions of corporate competitive skills, marketing abilities or utilization of other widely varying corporate resources.

This approach can increase for many investors the scope of needed inputs research, perhaps well beyond their abilities or appetites. At this time, I only know of one source* able to translate market actions in derivatives into expectations of underlying equity prices, but expect as its achievements become known, others will copy its methods.

Conclusion

Risks are taken by many investors without adequate evaluations of their probable cost and without appropriate estimations of the likely payoffs possible to offset their damage.

It is not entirely their fault, having been "carefully taught" by investment industry sources - ones widely believed to be "on their side" - that risk may be viewed as something that it is not. The rest of the fault content is what a Quaker college professor long ago labeled as "an undeserved tribute to the mental energies of mankind".

That failure to think through the negatives and match them against the positives often needs some disciplinary process support. One such can come from outside, and with time, may become more readily available.

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Additional disclosure: Peter Way and generations of the Way Family are long-term providers of perspective information [earlier] helping professional and [now] individual investors discriminate between wealth-building opportunities in individual stocks and ETFs. We do not manage money for others outside of the family but do provide pro bono consulting for a limited number of not-for-profit organizations. We firmly believe investors need to maintain skin in their game by actively initiating commitment choices of capital and time investments in their personal portfolios. So our information presents for their guidance what the arguably best-informed professional investors, through their own self-protective hedging actions, believe is most likely to happen to the prices of specific issues in coming weeks and months. Evidences of how such prior forecasts have worked out are routinely provided. Our website, *blockdesk.com has further information.

Disclosure: I/we 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.