"Risk" is a versatile, albeit somewhat ambiguous term in financial markets. Journalists like to say, "traders are paid to take risks," traders use risk often to mean a position in the markets, i.e. "I like this risk, so am leaving it on."
But really, what is risk?
1) Volatility - the mainstream academic and practitioner's method. Volatility can be standard deviation of returns in an absolute basis or relative to a benchmark. Have an equity portfolio that often swings 2x as much as the market on a daily basis? You are twice as risky as the market. Bond traders measure a bond position's "risk" by sensitivity to interest rates (e.g. treasury yields of matching tenor). If the bond position you have moves 10% if rates (treasury yields) move by 1% your duration is 10 and when converted into dollar terms (dv01, dollar value of a basis point), that's your risk.
Then for credit products/corporate products - what happens if the credit spread of your AA bond widens by one basis point? If your duration is 5, you lose 5bps of face/mkt value (depending on your specific definition of "duration" etc.). That's risk too.
The list continues, but idea is this - only a daily basis, how much could the market value of your investment change in value, either on absolute or relative to a benchmark? Or in other words, how much does the market herd affect your investment tomorrow?
2) Being "right", or permanent loss of capital. The value investor/distressed investor, used by many Michael Burry of Scion Capital, Howard Marks of Oaktree, and of course Warren Buffett of Berkshire Hathaway.
Who cares about the noisy of the crowd? What matters is when the investment matures (or over a long period), does the underlying investment make the money? I.e. for corporate bonds, will the issuer pay me back interest & principal?
Naturally, this is easier for fixed income than for equities (or is it?), since there is a built in catalyst (maturity). Nonetheless, if you buy FB on the belief that it will earn $10B a year in profits 3 years from now and are correct, the market price at that time will probably be higher. In other words, forget about tomorrow - how about many years from now?
3) Drawdowns - until your exit, how much can the market move against you? Disclosure: my personal favorite, though admittedly much harder to measure/reduce. Used by some fund managers such as Monroe Trout from New Market Wizards (portfolio wide stops of down x%, when he'd liquidate all).
If you want to buy FB in anticipation of that $10B net income (that your presumably researched etc), how much could the stock go down from now until then? Do you expect that eps growth will be linear, exponential, noisy? What if next quarter's eps misses? Based on the last miss, a 10%+ drop would be possible. But is that a reasonable comparison?
^Those questions are far harder to answer, but may be more fruitful? After planning your actions (if any) and adjusting the position size/composition, it might remove some of the emotions of a casino-like quality of investing.
Indeed, the final approach is, how much pain will there be until proven right or wrong?
What other thoughts on risk do you see?
Risk in trading is far more simple than people make it out to be—risk is simply path; the path of the price of the asset will take in the future—and, critically what your ability as a trader is to conform to that path. The path itself doesn't matter, it is your experience of the path. The path the asset took in the past doesn't matter--its the path the asset will take in the future that matters.
ReplyDeleteA trader who more successfully predicts the path of the price of an asset is the least risky trader. It’s not the asset, it’s the trader that determines the level of risk based upon his ability to predict the path of the price of the asset.
This concept is easy to illustrate. Let’s say a stock, over the last year has gone from $7.50 to $5.00 to $10 and back 5 times. People would typically say that stock is “volatile” and therefore more “risky.” One assumes that the danger is in the stock, and not in oneself. However, if a trader bought it every time it went to $5.00 and sold it at $10, reversing the position, the trader has experienced zero volatility. He has not experienced any risk.
Approached from this perspective, risk is much more easy to understand—and why smart people get it wrong so much.
Thus one can be trading the most volatile commodity, natural gas, and still be less risky than a trader of US debt, provided he can predict the future path of the price of gas better than the trader of US debt.
Thank you for the thoughts! I do believe that you are focusing on what happens when you are "right", or correct. What happens, if you incorrectly predict the "path"? How much could you lose? Unless every trade you make is 100% profitable, that strategy has risk, be it in volatility, etc. My point is, what if your path prediction is incorrect? What if you buy at the max highs and sell at max lows? Your "risk" is actually more than the underlying asset then, no?
ReplyDeleteAlso, even a 100% profitable set of trades which make $1 , $100, $2, $200, is highly volatile (though I would agree, not nearly as as "risky" as a portfolio of negative losses).
"Experiencing" risk is not the same as taking risk - you could be an option seller and not experience losses for years. A 99% correct system is still not useful if that 1% wipes out years of gains.
Finally, I make a distinction between predicting and trading an asset. The former has no pnl, while the latter does, and it makes all the difference. I can "predict" the sun will come up tomorrow and have 100% win rate, but who will take the other side? I can predict S&P will be above 500 for the five years, a path prediction, but will I get paid enough for it if I am wrong (this is a a put selling bet).