My name is Anders Bøgebeck. My mission is to help you become a better investor and trader. Why is this important? We are not only helping ourselves by becoming financially free. Along the way we help society by either allocating capital the right places or creating better products and services. That's why I want to help you achieve the life you desire!
In this blog post, I want to talk about different types of risk that a stock-trader as well as an investor faces for public liquid equity. This is important, because most beginners probably have heard, that you should not put all your eggs in one basket. But they end up concentrating a lot of risk by being unaware of the portfolio composition.
By not knowing how you place your bets, your outcomes will be very volatile returns, it will make you check your positions way too often and it will prevent a good night's sleep. The key to Modern Portfolio Theory is to look at returns in the light of the risk the portfolio i carrying.
The goal for every trader or investor is to:
Have a tolerable down-side risk while maximizing upside risk.
This is not only done by placing a stop-loss and saying: "well, all the bets are random and if I win I make 2 times the risk and if I loose I loose 1 times the risk.
The stock market does not work like a roulette table. There are human beings (most of the time) sitting behind a screen and looking at the same information as you do! So there is obviously some human aspect to the whole stock market.
Let's talk about some of the different risks you can face. Carefully understand the next five section before reading section 6.
1. Company risk
This type of risk is made up of bad news hitting a company in your portfolio. It can happen night and day and the next trading day, your position can gap down significantly. Luckily, this type of risk is rather easy to remove by diversifying. By holding 10-20 positions in your portfolio, you have reduced that risk to an absolute minimum.
2. Sector / Industry risk
It is not enough to buy 10 technology stocks and think you are good. Let's take the technology sector as an example: First of all, these stocks typically have high standard deviations and therefore they are pretty volatile. They are hurt worse than "defensive" sectors during downturns. Also, the market can experience a "sector rotation" where all stocks in a given sector / industry are hurt no matter their name. Therefore, always place your bets in at least different industries. If you have two positions open in the same industry, it is like doubling your risk. However, with that being said, there are a lot of big potential stocks in the technology sector, because our entire society is still making a big shift in how we use technology in our every day lives. Pick some great growing companies in different growing industries and you should be good.
3. Systemic risk
This type of risk is based on some political or weather event, which causes everybody to rush to their trading platform and sell all their shares immidiately. It's nearly impossible to know, when this type of risk occurs. That's because it happens all of a sudden. Luckily, you can hedge your portfolio with options, inverse ETF's or short positions to create a market neutral portfolio. You want to look for a portfolio composition with a high backtested Treynor ratio or a portfolio with a 0 US market correlation. This means, that your portfolio is neutral to a big sell-off. One easy way to get a high treynor ratio is to mix large cap growing tech stocks with either stocks in the utility, consumer defensive or healthcare sectors. These sectors are defenseive versus the technology sector. But remember to always be hedged against systemic risk. Here you will need some more ammunition like put options. The defensive sectors seem to balance off a market sell-off because they have a low US market correlation. But they will not give you the sleep-well kind of protection. By having a portfolio with 0 US market risk you can be pretty sure, that no catastrophic loss happens to you. Gold, silver, mutual bond funds, silver and gold miners and of course insurance will help with that task. Put options have a negative correlation to the US stock market, because they benefit from a broad market sell-off.
4. Asset class risk
If for some reason a political decision was made to stop the yields on bonds to be artificially low, a bond crash would likely happen. People holding very low yielding bonds would panic-sell. Then capital would rush into bonds and leave stocks, because of the "risk free" extra yield. This type of risk is a bit different from the systemic risk. This type of risk makes people abandon one asset class in favour of others. Luckily, by having a market neutral portfolio consisting of inverse ETF's, short bets or insurance, you will not get wiped out by these kinds of events. My favourite is buying cheap insurance, because inverse ETF's seem to me to be more counter-productive!
5. Inflation risk
This risk is made by fiat currency becoming less valuable as the government prints more and more of it. Cash and bonds are mostly hurt by this risk type. Stocks, real estate and basic commodities seem to increase in price by inflation. That's why, I would not call currency an investment, because it constantly looses value. Luckily for us, inflation is more likely than deflation. But if delation was to happen, an uncorrelated market portfolio would hedge a crash.
6. Safe leverage
By having a risk-adjusted portfolio, you will experience a portfolio with a lot less volatility (low standard deviation). The good thing about this is, that you can put on leverage more safely to your portfolio, because of the big stability. This would not be possible by just holding QQQ or SPY long! This is important to understand: You must eliminate all these types of risks before putting on leverage. And start out with a little leverage, because the standard deviation of your portfolio must still be manageable.
Be careful when constructing a portfolio. You must always picture the worst scenario happen. Because one day, it will happen! You will stop out of all your positions and what will remain in your portfolio is insurance or inverse ETF's. Be well prepared for that day before everyone else. A uncorrelated portfolio with a correlation score of 0 should save you. If you understand the risks you are taking, then prudent leverage will be your reward! Happy trading.
|Different ways to use PE ratios when valuating stocks||How to build the best stock portfolio with Portfoliovisualizer||Why fundamental analysis is not working in the stock market|