There are known knowns; there are things we know we know.
We also know there are known unknowns; that is to say we know there are some things we do not know.
But there are also unknown unknowns – the ones we don’t know we don’t know. Donald Rumsfeld, Former US Secretary of Defense
If I pose a general question to traders and ask them to define risk in a trading sense, I will generally get an answer that states what their percentage risk on a given trade is. This is not an incorrect answer – it is merely an incomplete one. Risk within markets is a multi variant problem that requires a bit of sophistication to both understand and manage. Part of the issue with traders is the inability to define what sort of risk they will be exposed to.
The moment we enter a financial market and make an investment, we are automatically exposed to two forms of risk. The first is avoidable risk – this is any form of risk which can be avoided and does not result in a reduction in potential performance. For example if I decided not to trade an illiquid market, I would be engaging in a form of avoidable risk reduction. The same case could be made for not using derivative markets when I have an incomplete understanding of them. I have made a decision that reduces my risk but does not impact upon my potential performance.
The second form of risk is unavoidable risk. Any form of unavoidable risk reduction will result in a reduction in the potential for performance. This is a little bit hard to understand initially but it becomes clearer when we look at the two main components of unavoidable risk – controllable risk and uncontrollable risk.
Controllable risk is what traders traditionally refer to as risk. This is the amount that is risked on each trade when it is initiated. Uncontrollable risk is simply those things we can never know until after they occur. These include things such as political upheaval, terrorism or the US banking system going face first into the mud because having an MBA apparently means you don’t understand that lending all the money you have to people who don’t have a job is a bad thing.
The key component here is the notion of a reduction in performance that flows from these two types of unavoidable risk. As said, this is hard to understand but it becomes clearer when we break these issues down into their components.
With regard to controllable risk, we have a narrow threshold of permissible risk that allows us to maximise our performance. If we risk too little then our performance is meaningless. For example, risking 0.1% on a trade would render most trades too small to be viable whereas risking 1% would make most trades viable and would result in a higher performance. Speculation must be worth the effort and it must be worth the effort when compared to alternative investment vehicles. We can see that excessive attempts at reducing this form of risk will lead to a drop off in potential performance. There is also a second side to this equation that everyone should be familiar with and that is risking too much is also detrimental to performance simply because losses build at an uncontrollable rate.
With regard to uncontrollable risk, or those things we cannot know, the only way to deal with these is to simply avoid trading all together. It is easy to see how this would affect our results since our potential return would be zero.
Once we enter the market, we also have some very subtle additional sources of functional risk that we have to understand and deal with and I have listed these below.
Time – the longer we are in the market the greater the probability of a move against us. This can seem a bit confusing but think of it simply as trends coming to an end. Whilst trends can last for extended periods, they eventually end. We have to accept that they do eventually end and to be prepared for this event. All too often traders are seemingly blind to changes in the market. Granted this blindness is generally related to either an incomplete system of a series of biases with regard to market direction but these reasons do not negate the fact that trends end.
Diversification – this is a very difficult concept for people to grasp. If you want an incorrect answer as to what diversification is, ask a stockbroker or financial planner. Their response can be distilled into the wisdom that if your shares have different names then you are diversified. This is a very unsophisticated answer since true diversification is very difficult within a closed equity market such as Australia. A truly diversified portfolio would have a structure similar to this –
1. USD Index or $A Spot
3. Heating Oil
6. High Grade Copper
The interesting thing with diversification within closed equity markets is that the more diversified you are – that is the more instruments you own the more your performance will drop. This occurs because you begin to replicate the underlying index, once this replication takes place you will never be able to outperform the index. I believe that diversification across a portfolio is a good thing – that is, your system is split across instruments, markets and time frames. I think diversification within a single market is pointless because you will only ever have a few good trading ideas.
Liquidity – traders, particularly those with a fundamental bias, often treat trading as if it were a treasure hunt with the aim being to find things before anyone else does. This often leads to the purchasing of extremely low liquidity instruments at what are perceived to be bargain basement prices. The problem with this logic is twofold. Firstly, if no one else wants it, why do you, and secondly, how are you going to convince anyone else of the value of your purchase? In addition to these problems, a lack of liquidity leads to a lack of price discovery, which in turns leads to increased volatility. Getting into an instrument is easy – it is getting out in a hurry that is the hard part.
Bid-Ask Spread – at any given time there might be 110 ASX stocks that have exchange traded options available to the trader. Many of these are household names such as BHP, RIO, WBC and NAB. However, many are not, and for some obscure reason (perhaps related to the notion of trading as a treasure hunt) traders insist on trading issues such as IPL, JHX and ORI, which have miniscule turnover.
The problem here is twofold. Firstly, the ASX allows these stocks to be listed, and secondly, a tiny band of traders want to try and trade them. Any optionable stock outside the top 10 by volume has very little turnover and the trader is at the mercy of the market maker. Note I said market maker singular. Most of these stocks only have one market maker, not several, such as with the more liquid stocks. As a result the bid-ask spread, whilst constrained by ASX guidelines, will usually be at its maximum because there is no one else there to provide price discovery.
All of these points should be considered within your trading plan. So that when you talk about risk you are not just focussed on the tactical issue of how much you will risk on any given trade but rather the strategic management of risk across your portfolio.