|
Know Your Enemy
- Risk Management
Risk is as much a part of trading and investment life as it is a part of life in general. Risk is nothing to be feared - provided it is understood.
Professional traders and investors understand the risks they are exposed to at any one time, and how they can manage those risks in order to achieve reasonable returns while being able to sleep well at night. There are many types of risks which effect traders. These include:
1. Interest Rate Risk
Many markets are sensitive to changes in interest rates. For every percentage point that interest rates rise, investments in stocks becomes slightly less attractive. If interest rates rise beyond a certain level, people start to sell their stocks in order to put their money in safer, high yielding, fixed interest securities. This places additional selling pressure on stocks and can result in a decline in the stocks' price.
2. Inflation Risk
Inflation risk is the risk that the future purchasing power of the returns from an investment in a particular security will fall after the affects of inflation have been taken into account. For example, if an investment is returning three percent per annum, and inflation is running at 10 percent per annum, the investment is not keeping pace with inflation. After tax., the situation may be considerably worse, depending on the investor's marginal tax rate. In other words, the purchasing power of the capital and income is therefore being eroded over time.
A decision not to invest, but instead to keep the money under a mattress on one's bed, is in effect a decision to erode the capital each year by the rate of inflation.
3. Exchange Rate Risk
Exchange rate risk primarily affects traders who trade overseas stocks. If an Australian trader buys, say, $50,000 worth of U.S. stocks, any movement in the value of the Australian dollar will affect the value of those stocks when expressed in Australian dollars. A falling Australian dollar increases the local value of stocks held overseas.
In 1996, the Australian dollar traded at 82 cents U. S. In recent years the Australian dollar has been losing value at the rate of approximately four per cent per annum against the United States dollar. The falling Australian dollar has therefore made a significant contribution to the return of Australian traders and investors who have had exposure to United States' markets during this period. A rising Australian dollar will have the opposite effect.
Australian traders who only trade or invest in Australian stocks can also be subjected to a form of exchange rate risk. If they buy shares in a company with significant U. S. holdings, say, the value of such holdings will rise or fall in line with movements of the Australian dollar relative to the U. S. dollar.
4. Competitive Advantage Risk
Some companies have a better competitive advantage in their market place than others. Trading or investing in companies with a strong competitive advantage therefore lowers the competitive advantage risk associated with that trade or investment.
5. Leverage (Financial) Risk
If a company is liquidated, some creditors are ranked ahead of others to receive payment. Shareholders are paid after creditors have received their money.
6. Sentiment Risk
Many people assume that traders and investors act in a rational manner. In reality, this is true for much of the time, but very untrue around major market tops and bottoms.
At major market tops the price of stocks is usually well above the fair value for the stocks. Traders and investors are very bullish and believe that prices will travel much higher. Greed is the driving force in the market.
At major market bottoms the price of stocks is usually well below their fair value. Traders and investors are very bearish and believe that prices will travel much lower. Fear is the driving force in the market.
At major market tops and bottoms, rational behaviour has given way to impulsive behaviour. Traders and investors who are susceptible to the influence of fear and greed take increased risks by trading and / or investing at such times.
7. Liquidity Risk
Some stocks trade in large volumes every day. Other stocks may not trade at all, for many days at a time.
A stock you can buy or sell at any time the market is trading, without your buying or selling effecting the market price to any significant extent, is said to be a liquid stock. There is a risk associated with trading or investing in an illiquid stock.
8. Diversification Risk
Trading or investing in only one stock is effectively putting all of your eggs in the one basket. It means that if you are successful, you will be very successful. It also means that should that stock perform poorly, the overall performance will be poor. To fail to trade a selection of stocks from different sectors is to increase one's diversification risk.
9. Professional Advice Risk
Some traders and investors prefer to take trades or make investments on the basis of the professional advice that they have received from an 'expert' advisor. Clearly, some advisors are better than others. There is therefore a risk associated with taking advice from a not-so-competent advisor.
10. Broker Risk
In the early part of the 20th Century, a number of broking houses went bankrupt. Clients lost much or all of the money they had in accounts with these brokers. Today there are mechanisms in place to help protect clients should broking firms fail.
A less severe form of broker risk occurs when a broker achieves consistently poor 'fills'. Poor fills cost clients money.
11. Traders' Risk
Some traders are more risk averse than others. Some are comfortable taking high risk trades in the hope of achieving high returns. Others prefer to accept a lower return in exchange for knowing that the risk is also lower.
Some traders trade in a totally disciplined manner. They follow the rules of their proven trading strategy and are not unduly influenced by the emotions of fear and greed. Such traders have a low traders risk.
In conclusion, it is impossible for traders and investors to completely eliminate risk. Even placing one's capital under the bed has at least two risks associated with it. The most severe is the possible theft of the money. The lesser or the two risks is the risk of the future purchasing power of the money being eroded by inflation. A decision not to trade or invest one's capital therefore still involves accepting risk.
There is little point in traders and investors worrying unnecessarily about risk. The key to risk management is in understanding the risk associated with any action one is taking at any one time, and taking the necessary steps to minimize any negative effects of the risk. The successful management of risk is a crucial prerequisite for consistently profitable trading and investment.
"For more information on how you can maximize your trading profits while strictly controlling your risk, click here..."
DISCLAIMER:
Every effort has been made to ensure that the content and conclusions presented in MasterStroke are complete and accurate.
No part of MasterStroke contains trading advice - stated or implied, nor is an invitation to trade. The directors and associates of Market Masters Pty Ltd are NOT licensed trading or investment advisors. Market Masters Pty Ltd is an organization designed to assist traders and investors to become more knowledgeable and independent.
The giving of advice is therefore contrary to the very objectives of Market Masters Pty Ltd.
Traders requiring trading or investment advice should contact a licensed advisor. Stockbrokers and futures brokers are licensed advisors.
Neither Market Masters Pty Ltd, nor anyone else involved in the production of MasterStroke, will be liable for any liability, loss or damage directly or indirectly caused, or believed to be caused, by MasterStroke.
Traders, to be successful, must take full responsibility for their own actions.
With respect to trading results, past performance is not necessarily an indication of future performance.
By maintaining your subscription to MasterStroke, you acknowledge that you understand and accept the contents of this disclaimer.
Neil A Costa
|
