Summary: Portfolio managers talk about Stock risk not in terms of loss but in terms of variability of their returns. This way of looking at risk can also be valuable to stock traders.
You take a risk every time you drive to work, or fly in an aircraft, or cross the street. You take a risk when you dine out with your date. You take a risk when you trade shares hoping to get rich.
What Does Stock Risk Mean?
Each of the examples above describes an action you’ve taken to achieve something you want. Associated with each action, however, there is also the chance of an outcome you did not want – be that serious injury in a car accident, food poisoning in a restaurant or losing money in your stock-trading activities.
In order to trade stocks successfully, you need to understand Stock Risk – and not only the risk of losing money in a trade that goes bad.
To professional portfolio managers, a high-risk portfolio is one in which the returns are highly variable. Risk management of these investments are very important.
For example, here are the five-year track records of two stock portfolios:
Portfolio A Performance Summary
- Average Annual Return +39%
- Annual Compounding Rate +31%
Portfolio B Performance Summary
- Average Annual Return +6%
- Annual Compounding Rate +6%
Portfolio A, compounding at an average rate of +39% per anum, would be described as high risk, because the annual rate of return is highly variable.
Portfolio B, compounding at an average rate of +6% per anum would be described as low risk, because the annual rate of return changes little from year to year.
The portfolio manager’s definition of risk seems to be lacking in that it fails to take into account the ‘risk’ that your rate of return is lower than you expected. There is a high ‘risk’ that you will not grow wealthy with Portfolio B.
On the other hand, how many of us would have the nerve stick with a portfolio (or a trading methodology) like A, that lost 20% of our funds in its first year? To that extent, we can sympathize with the portfolio manager’s definition of risk.
To further examine this definition of Stock risk, which trading strategy would you rather follow from the two below? Which of the two would you be most likely to stick with after sitting down and reviewing the first year’s performance? Be honest now!
Results: $100,000 allocated to A will grow into $380,160 while $100,000 allocated to B will grow into $381,164.
Traders following strategy B would sleep more easily at night than those following A. Furthermore, many beginning traders using Strategy A would give up after their first year, believing their trading skills to be poor, even though Strategy A would reward them handsomely over a longer period of time.
For this reason, when you are choosing your trading strategy, it’s important to consider variability of return. When you are testing new strategies, you should select those which yield good profits AND have low variability in yield.
Short Term Trading Stock Risk
Regardless of time scale, a stock’s price direction is always determined by supply and demand.
Short term supply and demand are more readily manipulated. For example a guru in a large circulation newspaper might tip a stock at the weekend. On Monday, propelled by demand from eager newspaper readers, the stock’s price rises.
A slightly different scenario that experienced investors will be aware of is when the stock’s price does not rise on Monday, despite an army of small investors buying shares. It turns out the “guru” was helping friends who wanted to sell large shareholdings. A neat way of doing this without driving the stock’s price down was to create artificial demand among small investors.
It is much easier to artificially influence a stock’s price in the short term than the long term.
Benjamin Graham once said, “In the short term the stock-market acts like a voting machine, in the long term it’s more like a weighing machine.”
In other words, supply and demand on any given day can be driven by all sorts of factors – some stranger than you might imagine. BUT, taking a long-term view, trivial factors are discarded in favor of the weight of cash the company has delivered to its shareholders and can be reasonably expected to deliver in future.
Big market traders play games of bluff and double bluff on an hourly and daily basis.
If someone has sufficient funds – and banks and investment houses do have the funds – it’s easy to move a stock’s price through large-scale buying or short-selling.
Having moved the price enough to trigger short-term buy or sell signals to technical analysts, the idea is that these technical analysts will trade in the direction of the technical signals. This generates increased trading in the stock and the price moves even further in the direction that the “big players” intended. The big players then dispose of their position in the stock. The trend comes to an end and the traders who entered it late lose money. The big players, though, have profited handsomely.
If you want to trade short-term, your opponents will almost certainly be better equipped, better funded and more experienced than you. 85 to 95 percent of people who try to become short-term traders fail.