Every decision we make has its advantages and disadvantages, we never hit it right on the target, but we keep trying to learn how to miss by the least.

So every-time since we wake up in the morning we are faced with lots of choices. Some of those decisions are made mechanically, intuitively, some others need a cost/benefit analysis.

Investments are no different from everyday decisions. When we are taking investment decisions we need to analyze risk and reward. But we often forget about the former, and only concentrate on the later. If you take a look at financial instruments like mutual funds, stocks and bonds you’ll have little trouble finding the expected return those investments offer. But it won’t be as easy if you try to find the risks associated with those investments.

We need to quantify risk as well as we quantify return:

While mutual funds provide precise return numbers, most risk disclosures are still vague at best. For example, most mutual funds convey their proclivity for assuming risk with only generic labels like, “aggressive,” “balanced,” or “moderate”. Risk should be quantified as rigorously as returns. How would you feel if your mutual fund statements reported that your last quarter’s returns as “conservative” or “moderate”, instead of stating the actual return number?

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But the problem with risk is that there isn’t a simple magic number to measure it. Properly assessing risk is more an art than a science, let’s find out why.

Elements of risk

There is a huge list of risks in every activity we do daily, although most of those risks are so familiar to us that we don’t even remember or take care of them (i.e. crossing the street, driving, etc.). But what is risk after all? What is risky for you isn’t necessarily risky for others. So we need to know how to measure risk in a specific way that anybody can interpret without misunderstandings. The two basic facts that define the relevance of any risk are:

• Probability: risk probability assessment investigates the likelihood that each specific risk will occur.
• Impact: risk impact assessment investigates the potential effect a risk can take if it occurs (the size of the potential loss).

For instance, the impact of an airplane crash means almost always death, whereas a bus accident not necessarily ends up in a complete tragedy. But the probability of an airplane crash is almost zero so the overall risk of flying is a lot lower than the risk of driving or travelling by bus.

Volatility and Risk

The standard deviation of the price of an asset (also known as “volatility”) indicates the potential size of losses or profits it can give as an investment. Volatility is usually mentioned as a synonym for risk.

One of the most biggest mistakes in my opinion is the common notion of volatility as a synonym for risk. Investments are categorized as more risky or less risky by their volatility, but as I have said before, volatility indicates the potential size of losses….or profits! Volatility is not necessarily a bad thing, it can be indeed a great factor.

We tend to put more stress on impact than we put on probability, usually because of fear caused by not knowing about the subject. To achieve an acceptable estimate of the probability of an event you must develop knowledge and experience. Then when you are experienced you are willing to take more risks…controlled risks (low probability, higher volatility) to expand your returns without increasing your overall risk.

Risk response strategies

Planned risk responses must be appropriate to the significance of the risk, the plan must address the risks by their priority. These strategies typically deal with threats or risks that may have negative impacts on your objectives, if they occur:

• Avoid: this strategy involves changing the plan to eliminate the threat posed by an adverse risk. Some risks that arise early can be avoided by obtaining information and/or acquiring expertise.
• Transfer: risk transference requires shifting the negative impact of a threat, along with ownership of the response, to a third party. One of the most common transference tools is the use of insurance. In the case of stocks, you can limit your downside risk by buying put options of the stocks you own.
• Mitigate: risk mitigation implies a reduction in the probability and/or impact of an adverse risk event to an acceptable threshold. This strategy can be achieved in investment activities like real estate or your own business. In bonds, stocks and commodities it is almost impossible to mitigate risks because the factors affecting these kind of assets are out of our control.
• Acceptance: sometimes there is no response strategy available or the cost of dealing with the risk is greater than the risk itself. In that cases you must establish a contingent reserve to handle known/unknown threats. For example it is not recommended to sell a stock on every minor pullback if you are investing for a longer term, since the costs of commissions and slippage can eat your return.

Contingent response strategy: the probability and/or impact of some risks justify the design of a response plan, these plans are used only if certain events occur and these events should be defined and tracked. For example always before you buy a stock you should already have a plan for the entry (entry price), to sell at a profit (profit target) and to sell at a loss (stop loss) if the price goes against you.

Common investing risks and strategies

There are several types of risk you need to analyze, but a top down basic list would be: Global risk, Country risk, Sector/Industry risk, Company risk.

• Global risk is related with the macroeconomic situation globally and how it affects the markets. It includes interest rates, GDP growth, currencies, commodities, etc.
• Country risk is related with the macroeconomic situation locally. It also includes the former subjects, but from a local perspective.
• Industry risk deals with the situation of a sector or industry within a single country. For instance the current internal conditions of the real estate industry in the US aren’t as healthy as other industries like oil related industries.
• Company risk is involved in the risks inherent to a particular company. It is concerned with the degree of debt the company has incurred into, the revenues/profits forecast, the cash-flow prospects, the skills of the management team, etc.

Several known strategies have emerged to treat market risk properly. The more important are:

• Diversification: you can minimize risk by spreading your investments, and avoiding an over-concentration in any single company, industry, or country. Studies show that reasonable diversification can be achieved with as little as a dozen stocks. Moreover since the becoming of ETFs (Exchange Traded Funds) diversification is easier than ever to achieve. You should also diversify among different investments like stocks, bonds, options, futures, real estate, businesses, etc.
• Money management: this is one of the most important concepts of all in investing. It is impossible for you to win every-time you trade so you have to allocate a limited amount of money to any particular position. Professional money managers don’t risk more than 1% of their accounts in a single trade. If you always invest all you have got in one bet you are putting yourself in a very difficult situation, because at some time you will be wrong and you will lose all your money.

Summing it all up

I think the worst risk of all is ourselves. Many people believe investing is risky, but when you become more knowledgeable in investing you realize that WE are the ones who are risky! Ignorance and lack of information make us risky.

Usually, people let others decide what to do with their hard earned money. The problem is we almost always seek advice from salespeople, not rich people. Most stockbrokers are not rich nor do they invest in what they sell. There’s a famous quote from Warren Buffett (the most successful investor of our time) that says:

Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.

To learn how to make bread you should ask a baker. To learn how to invest successfully you should study the lives of the pros, reading/watching their biographies and getting to know how they make decisions and how they think.

Risks are moving targets, what is not risky today might be risky tomorrow. The best way to treat risks is by learning how to identify and measure them, and by making plans to defend ourselves from those events whether they occur.

We can’t expect to get anywhere if we avoid taking risk. History shows that great accomplishments have always involved taking significant calculated risks in one form or another.

Rather than avoid risk entirely, avoid taking poorly understood risks. Take risk only when the upside justifies the downside. The ability to understand and measure risk will empower you to make better investment decisions.

Usually when we talk about the stock market people say “the stock market is pure luck, it’s like a casino, there’s no way to make money out there…”. I used to have difficulties explaining the differences I found between the stock market and casinos until I read “Come into my trading room” from Alexander Elder. The following is an excerpt from the book:

Most people gamble at some point in their lives. For most it provides entertainment, for some it becomes an addiction, while a few become pros and make a living at it. Gambling provides a living for a very small minority and entertainment for the masses, but a casual gambler reaching for a quick buck has the same chance of success as an ice cube on a hot stove.
Some card games, such as baccarat, are based on chance alone, whereas others such as blackjack, involve a degree of skill that attracts intelligent people. Professionals treat gambling as a job. They keep calculating odds and act only when mathematics point in their favor. Losers, on the other hand, itch for the action and enter one game after another, switching between half-baked systems.

Trading is the most exciting activity that a person can do with
their clothes on. Trouble is, you cannot feel excited and make money at the same time. Think of a casino, where amateurs celebrate over free drinks, while professional card-counters coldly play game after game, folding most of the time, and pressing their advantage when the card count gives them a slight edge over the house.

So the answer to the title is YES! The stock market is very much like a casino, because the vast majority of ignorant individuals get bust trying to make some easy money. “The house” (the major brokers, the “market makers”) eat them alive. Yes, it is very difficult to consistently beat the market as an individual trader, for instance take a look at the large investment institutions: they have a ton of analysts and traders who work every single day trying to find the best opportunities. And a lot of them fail too, so what’s left for us?!

Anyone can make money on a single trade or even several trades. Even in the casinos of Las Vegas you continuously hear the music of the jackpots. Coins pour from the slot machines, making a happy noise, but how many players go back to their rooms with more money than they came with? In the markets, almost anyone can make a goodtrade, but few can grow equity.

To be a successful trader, you have to develop iron discipline (Mind), acquire an edge over the markets (Method), and control risks in your trading account (Money).

The next posts on this subject will be about trading psychology, trading systems, and money management, which are the tools we need to master in order to be successful in trading.

But there’s a big difference between the stock market and a casino game. Casino games were made to make it almost impossible to beat the house, anyway there are a few systems for getting an edge on some of those games like the roulette and blackjack. Some skilled people happened to master those complicated systems, they broke the bank in casinos all over the world until they weren’t allowed to enter one any more, no more casinos let them play.

One of my favorite clients is a professional trader in London who
sometimes, for entertainment, goes to a casino at night. He plays
blackjack for a minimum stake of £5 and quits when he is either £200
ahead or £400 behind. He has worked out a card-counting method
and a money management system that have him going home with £200
13 times out of 14. He has proven to himself that he can steadily win
at the casino, and now he rarely goes there because he must spend
6 or 7 hours counting and betting before reaching his winning or losing
limit. It is hard work, counting all the time. The crowd of amateurs
around him is having a lot of fun losing. My client prefers to stay home
and trade stocks where the odds are much more to his liking.

The stock market is a very complex environment with countless variables, but at the same time there are a lot of systems, usually easier to follow, and the probabilities of success are way beyond those of the casino games systems.

Stock trading is not for everybody, it is a complex profession and it has nothing to do with gambling. It takes years of study, preparation and practice. The good news is Internet has made it possible for people like you and me to start with little money, open an account in a discount web broker, get all the relevant information for free most of the time. So the only thing you need at the beginning is time to learn, and to practice “paper trading” (trading in simulation platforms).

Are you ready?