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.Сувенири