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Showing posts with label Risk Management. Show all posts
Showing posts with label Risk Management. Show all posts

Tuesday, October 2, 2012

Managing Two Types of Risks in the Stock Market

One of the hardest challenges for investors in the stock market is managing risk.

There are at least two parts to managing risk.

1. The first part involves understanding what is a realistic potential reward for the amount of risk you are willing to take.

2. The second part is determining exactly how much risk you can tolerate and still be comfortable with investing.

Risk and reward go hand-in-hand, but they are not always balanced. For example, one stock may present a significant amount of risk, but given economic and market realities can only deliver a much smaller potential reward. In simple terms this means you will take way too much risk for far too little potential reward. Assessing potential reward involves understanding the company, its industry, the economy and market forces at play.

Even excellent companies face strong head winds when economic and market conditions are not in their favour. For example, a homebuilder, no matter how strong it might be in the market would've had a difficult time returning much of a reward to investors during the financial crisis that began in 2008.

It is not good enough to be a financially strong company if the economic and market cards are stacked against you. If you are a long-term investor and are very patient this kind of scenario may work to your benefit.

However, will only work if the price you pay for the stock is low enough so that any current reward is commensurate with the stock price and any future reward is predicated upon economic and market conditions changing to a more favourable position for the homebuilder.

Continuing our example, it would've been unrealistic to expect homebuilder to return 12 or 14% a year during the worst housing crisis in modern times.

If you are willing to wait for economic and market conditions to favor the real estate industry this company may have been made be a good long-term investment.

If the stock price was unrealistically high considering the conditions in the financial markets and the real estate industry, the stock may never achieve the kind of returns that most investors expect and need.

This is one of the prime reasons that when you evaluate a stock you examine not only the company but also its industry and how that industry fits into the economy and current business cycle.

One of the other ways long-term investors make money is by managing the level of risk so that they're comfortable with their investments.

Risk is a part of investing in stocks. You can't avoid the risk, but you can decide how much you are willing to take.

Not all stock investments are equal when it comes to risk. Smaller and newer companies are a greater risk than larger, more established companies are. Of course, in a severe down market, it may feel like every stock is in a free fall.

The question is how much risk are you willing to take?

In general, the higher the risk, the larger the potential reward should be. You should expect more conservative investments to produce lower returns.

The task for investors is to match their tolerance for risk with investments that will meet their financial goals.

But, how do you know how much risk you can tolerate?

A variety of "tests" on the Internet are available to measure risk tolerance.

We don't put much value in these tests. Here's why: When nothing is at stake, people tend to over-estimate their tolerance for risk.

A good analogy is playing poker for chips that you get for free contrasted with playing poker for real money. There is a significant difference in the way you play the game. When nothing is at risk, you may make wild bets and outrageous bluffs. However, when your actual money is on the table, most people will play much a much more conservative game.

Another way to think about risk is to consider this scenario:

If we offered you an investment and said, "there is an 80 percent chance this investment will be profitable," many people would say that's a reasonable expectation.

However, if we said, "there is a 20 percent chance this investment will lose money," many people would say that is too much risk.

Yet, it is exactly the same investment. The point is how you view your money and risk determines your risk tolerance. Most people know instinctively that some risks are too high, but not every investment presents an obvious risk you can gauge.

For most investors, finding their risk tolerance is a matter of experience. It is important that you avoid letting friends or your broker talk you into an investment that keeps you up at night.

You may need to adjust your financial goals to reflect a lower tolerance for risk, but keeping your risk at a comfortable will help keep you on track with an investment plan.

Saturday, September 4, 2010

Management Offering EPS Guidance

Markets are more often fixated with the EPS (earnings per share) guidances offered by company managements during the earnings season. The guidance is generally an indication of just the next three to nine months performance. However, investors tend to take them rather seriously. And by doing so expose themselves to some grave risks.

Offering conservative guidance and then outperforming them comes easy to large companies during high growth periods. But investors mistake such outperformance as perennial. And in the bargain, end up paying high valuations for the same.

Similarly, marginal underperformance during temporary slowdown often leads investors to lose faith in the business. This could rob them of a perfectly sound long term investment at even cheaper valuations.

But the risk of earnings guidance is even more profound in case of smaller or lesser known companies. Brokers hosting investor meets for lesser known companies during the result periods are commonplace. These typically serve as a platform for the companies to boast of unrealistic earnings estimates. The brokers in turn get a chance to popularize the stock in the street and generate more business. The only loser is the small investor who takes the guidance too seriously without checking more critical data points. And this, we fear, leads to most of them lose faith in stocks forever.

A good earnings season, like the one just gone by, is therefore a critical test for long term investors. It tests his or her ability to separate the wheat from the chaff. As also the ability to ignore near term promises and keep an eye on long term values.

Monday, August 30, 2010

Your Investment Profile & Risk Tolerance

To get an idea of your investment profile, start by calculating your investment horizon.

Investment Horizon:

Investment horizon is the period of time, in years, that you wish to remain invested. Investment horizon may be measured as the point in time when you begin taking distributions, or it may be measured as the point in time when you expect to complete taking distributions.

This is the number of years that you can invest. Your investment horizon depends on your financial goal.

Financial Goal:

A financial goal is a goal that involves saving and investing to reach a specific amount by a specific date.

For example, a financial goal may be to save 2,00,000 for a college education fund for a child in 14 years, or it may be to save 30,00,000 for a retirement fund in 20 years.

You can achieve your financial goals through a combination of saving more, saving longer or earning a higher rate of return.

Your goal may be to save for college, retirement, or a down payment on a home. Each goal has its own investment horizon.

For example, saving for retirement at age 65 when you're 20 gives you an investment horizon of 45 years. The longer the investment horizon, the longer you can save and benefit from compounding.

Next, estimate your risk tolerance.

Your risk tolerance is your willingness to accept some volatility in the rate of return of your investments in exchange for a chance to earn a higher return.

If you expect a higher rate of return, you should be willing to accept a higher degree of risk. This is called the risk-return trade-off.

Risk-Return Trade-off:

A basic investing principle that says the higher the potential rate of return, the higher the investment risk. Academic and industry studies support this relationship.

For example, stocks historically offer a higher rate of return than bonds. They also have a higher degree of investment risk. Investment risk is measured by the volatility of investment returns.

To get an idea of your risk tolerance, take a few minutes to complete the below risk tolerance quiz:




































To get your own profile add the number of points for all seven questions

Add one point if you choose the first answer, two if you choose the second answer, three for the third and four points for the fourth question.

If you score between 25 and 28 points, consider yourself an aggressive investor.

Aggressive Investor:

An aggressive investor is an investor who is willing to accept a higher degree of investment risk in exchange for a chance to earn a higher rate of return.

Investment risk is the volatility of investment returns. A basic investing principle states that a higher degree of investment risk is required to earn a potential higher rate of return.

If you score between 20 and 24 points, your risk tolerance is above average.

If you score between 15 and 19 points, consider yourself a moderate investor.

Moderate Investor:

An investor who is willing to accept some investment risk in exchange for a chance to earn a higher rate of return. Investment risk is the volatility of investment returns.

A basic investing principle states that a higher degree of investment risk is required to earn a potential higher rate of return. On the risk-tolerance scale, a moderate investor is in between an aggressive and conservative investor.

This means you are willing to accept some risk in exchange for a potential higher rate of return.

If you score fewer than 15 points, consider yourself a conservative investor.

Conservative Investor:

An investor who is unwilling to accept a higher degree of investment risk in exchange for a chance to earn a higher rate of return. Investment risk is the volatility of investment returns.

A basic investing principle states that a higher degree of investment risk is required to earn a potential higher rate of return.

If you have fewer than 10 points, you may consider yourself a very conservative investor.

This is only an example of a short quiz used by financial institutions to help you estimate your risk tolerance. For specific investment advice, you should always consult your financial adviser.

Friday, August 27, 2010

Money Management Odds?

Every day millions of investors keep on losing money, investing in what they perceive as good and logical investments.

In the end, it's not logic, or research that causes failure. It's playing against the odds!

The most important aspect to your trading, is money management. Money management is that portion of one's trading system that tells you what portion of your money should you put on a given investment. How much risk should you be willing to take?

Many investors mess up an incredible number of opportunities by not following proper money management routines. In the end, it was all Murphy's Law in action.

The stocks that we were the most sure, they hurt the most. The stocks we were afraid of went up through the roof.

We must not try to make a fortune on just one single pick, but we must not lose big either; it's the overall portfolio's growth and the... Ability to sleep at night that will make us successful.

Do not subject yourself to a lot of stress by investing heavily in each position, and do not freeze if a position goes against you, because you are already in too deep.

Position sizing and buying at the wrong time will be your biggest mistake.

Buy 1,000 shares of a stock and watch it go down the next day. By the time your stock would come back up, you will be a much humbler rabbit, ready to sell just to break even.

Then several days later, the stock is 20 points higher, but you are already out of the game.

Instead of investing aggressively, build positions in stocks in small increments. The risk in each stock is drastically reduced, and you will have what it takes to stay the course. Instead of taking major positions in each stock, spread yourself across a variety of stocks using multiple small buys.

Less risk, and greater returns!

Thursday, August 26, 2010

How to Manage Investing Risks?

"To make a mistake is only human; to persist in a mistake is idiotic." - Cicero (106 - 43BC)

Reduce your risks by:

Setting your sights on the long term, patiently riding with the ups and downs!

If you have the time to be patient, you can benefit from time diversification. The more numerous good years for stocks outweigh the bad, pulling your return up.

Thus, if you hold equities for many years, you can expect to realize significant positive growth in your wealth.


Weeding out your laggards!

Don't be too patient with laggards. This is the management risk referred to earlier. Underperforming the market benchmarks is a big risk to which many people are oblivious.

The more years you remain with a subpar performer, the greater the damage to your nest egg. Weed out funds that have lagged their peers over the past 18 to 24 months.

Avoiding hard-core market timing!

It's not uncommon for hard-core market timers to move between the extremes of 100% stocks during an up market to 100% cash when their indicators signal a major turning point in prices.

Market timing is especially easy to do with mutual funds. Resist the temptation.

Participation in the best up months is far more important than avoiding the worst down months, and the really dramatic upward surges in stocks are unpredictable, of short duration, and few and far between. Market timers risk being in cash when the bull stampedes. Missing out can make a big difference in your long-run returns.

Being disciplined and using cost averaging!

Investing monthly in a specific stock is a great way to build wealth and cope with market ups and downs. Your fixed investments buy more shares when prices are down and fewer at higher levels.

Cost averaging can help people become more disciplined because it encourages investing during market nadirs when individuals otherwise might be too fearful.

A particularly good strategy is to double up on your investments when prices are depressed, if you're able to. This will help enhance your long-term performance, by further reducing your average cost per share.

Understanding Stock Market Risk

"Take a chance! All life is a chance. The man who goes the furthest is generally the one who is willing to do and dare. The 'sure thing' boat never gets far from shore." - Dale Carnegie (1888 - 1955)

In 1998 Economics Professor and Nobel Prize winner Paul Samuelson (1915 - 2009) noted that: "Many people now believe that if they simply hold stocks long enough they will not, lose money for statistics have shown that since 1926 the U.S. equity market has not suffered a loss in any given 15 year."

He called it a fallacy, and conceded that it is truly likely that if you hold stocks over long periods of time that they would tend to produce returns higher than other assets. But to believe that it is a God given statement, Is simply not correct.

Investing and stock market risks do not go to zero over long periods, but there are many articles that reflect how risk goes down the longer the time period. What is seldom introduced is the fact that if there is a significant onetime loss, it can be monumentally overwhelming.

In any case, Samuelson noted that: "The problem is that when stock prices do turn down (as inevitably happens even in the strongest of bull markets) your optimistic equity exposure can overwhelm your gut level risk tolerance, leading to poor short-term judgments and even outright panic"

Risk is a complex, multidimensional concept that manifests itself in various ways. Risk is omnipresent and includes stock market crashes, corporate bankruptcies, currency devaluations, changes in sentiment, in inflation and interest rates, and even major changes in the tax code.

Risk is generally defined as return volatility, or the degree of ups and downs of returns. But there's more to risk than volatility. Risk and long-term reward are generally related. Risk is the chance that your actual return will be less than you expected.

People sometimes think that a good return can be achieved with little or no risk. Unfortunately, that's impossible. To achieve your objectives, you need to assume certain risks and avoid others. Your ability to handle risk is related closely to your individual circumstances, including your age, time horizon, liquidity needs, portfolio size, income, investment knowledge, and attitude toward price fluctuations.

What's highly risky to one individual may be no problem to another. Short-term fluctuations are not that relevant for long-term investors who have the discipline, patience, and understanding to deal with them. Stock funds are actually less risky than money market funds for those with long time horizons.

Well-informed investors are far less likely to let risk get the best of them. Those who understand the various elements of risk are better equipped to enjoy a profitable long-term investment journey.