Managing Risk

Over the years I’ve been fortunate enough to get to know thousands of market participants. Some are long-term investors others are scalping pennies per trade on thousands of shares while others manage millions of other people’s money. The interesting theme I picked up on with nearly every one of them is that they each experienced panic and uncertainty at certain times in the market. Oftentimes, this panic stems from the inability to make sense of the market, to gain control of market participation. Thoughts such as whether or not too much capital is at work or perhaps not enough or even whether or not to be in the market at all seemed to consume them.

This ambivalence can consume and debilitate even the best market participants. The uncertainty or self-doubt about market participation is common yet finding a solution is not. The greater the level of uncertainty felt the higher the odds are that risk is being misperceived. Here are some questions that I’ve asked to assess whether risk was real or perceived:

  • What are your reactions, both physical and emotional, to a losing trade? A winning trade?
  • Have you rationalized recent losses?
  • Has your out-of-market homework/research fallen behind?
  • Do you monitor your positions by dollars or percentages?
  • Have you ever not taken a trade that made sense simply because you were burned before?
  • Has the number of indicators you use to enter/manage/exit a position increased/decreased lately?
  • Do you know the Beta of your portfolio?
  • What would others say about you when asked about your risk management?

In a sense, managing risk involves managing the emotional side of trading so that the focus can be on the cognitive side of trading. As an example, if I’m concerned with the direction of the market because my traditional analysis methods are giving unclear signals then it probably doesn’t make much sense for me to participate. My biases will impact the data, whether it’s of a technical or fundamental nature, and lead to poor decisions. If I’m unable to clearly define what sectors are leading and which are lagging and, more importantly, why they are moving in the direction they are, then my risk is skewed. It’s times like these that large losses can accrue as objectivity is clouded by subjectivity.

I’ve always used sleep as a gauge to help me know if I’m in-line with real risk. If I’m able to sleep at night and wake up excited to participate in the market then I know that the odds are good I’m managing my risk. If I’m unable to get a good night’s sleep and lay awake wondering about positions I have on the odds are good that my risk management is off. Yea, I’m pretty simple.

Successful Traders Must Have Discipline

Discipline is paramount for success over the LONG term. Every trader has a limited amount of capital (money) available to trade. The trader without discipline will make trades, be quick take the profit when he is right, and call his trade an investment when he is wrong. 

This action of cutting winners and letting losers run will almost certainly eventually lead to trading capital being wiped out. The natural tendency in humans is to take profits.  Learning to cut losing positions and let winners run is a skill that must be developed. 

 Have you ever caught yourself saying any of the following statements to justify inaction on cutting a losing position?

  •  I am holding on to this trade and hoping it recovers 
  • If I didn’t own it already I would be buying it here
  • I just want to get back to break even and then I will get out
  • The market is wrong

Everyone has said these things at some point in their trading lives, but let me tell you, any time your position requires HOPE it is likely HOPELESS!

If you say I would buy it here and you don’t want to buy more – you may be better off selling what you have!

The market doesn’t know or care what price you bought a position. The market price of a stock is the value of that stock right here, right now!  Even though the market presents opportunities, market pricing is not WRONG. 

While I am not giving buy sell or hold advice, I would strongly recommend that when you find yourself staring at a losing position consider selling it! If you  close it out completely,  you can really make an honest determination when you ask yourself, “Do I REALLY want to own it here?” 

Too often I see traders let their existing positions do the talking for them. Don’t fall into that trap!

Time – Space – Reality – Oneness – Markets

What do the above all have in common? That’s right, “nonlinear” concepts!

It is interesting that one of the great minds of humanity, Albert Einstein spent his time on “nonlinear” concepts such as “time, space, reality, and oneness.” I find it more interesting that the interdependence of these “nonlinear” concepts is what makes a market tick as well.

As a trader, “timing” your trade within the “market” is based on “reality” in relation to the “oneness” of other traders and your outcome is determined by the “space” or movement of your position.

It is my opinion based on consulting with many traders that most traders incorrectly view the markets from purely a “linear” mindset and instead should view the markets from a “nonlinear” mindset as the markets are “nonlinear” themselves.  This is why rigid logical thinkers or “linear intellectuals” find trading the markets so frustrating.  Since they operate from their logical “linear” “beta” mind state, and become frustrated when market behavior does not do what it “should.” This is also why I feel that successful trading has to be both “art” & “science.”

Think about how you approach the markets and to what degree you are a “linear” vs. a “nonlinear” mindset. Also try and remember a trade or trading day where it seemed effortless and you just “let-go” and flowed with the market. In days like these, I’ll bet logical thinking was secondary to enjoying yourself, and selecting trades based on both your trading “tools” and your “intuition” which represents trading the markets as an “art” & “science.” Compare that to days when you where frustrated because the market did not do what it was suppose to based solely on logical assumptions.

Usually fear and greed are by products of logical thinking. Fear and greed are emotions and “nonlinear” in concept, but created by “linear” thinking. Isn’t it interesting that fear and greed are present in the markets and are “nonlinear” as well. Or is it because fear and greed are “nonlinear” and that they are present in the markets?

Maybe the key to a good trading system should be based on how to measure or determine “nonlinear” market events such as fear and greed. The purpose of this article is to have you look at the markets from a “nonlinear” point of view so that you can perhaps “see” market relationships that where invisible to you before.

Warren Buffett: How I Choose The Next Person To Run Berkshire Hathaway

“Four years ago, I told you that we needed to add one or more younger investment managers to carry on when Charlie, Lou and I weren’t around. At that time we had multiple outstanding candidates immediately available for my CEO job (as we do now), but we did not have backup in the investment area.

It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed. Finally, we wanted someone who would regard working for Berkshire as far more than a job.

When Charlie and I met Todd Combs, we knew he fit our requirements. Todd, as was the case with Lou, will be paid a salary plus a contingent payment based on his performance relative to the S&P. We have arrangements in place for deferrals and carryforwards that will prevent see-saw performance being met by undeserved payments. The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains. Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses. Investors who put money with such managers should be labeled patsies, not partners. (more…)

Atkeson & Houghton, Win By Not Losing-Book Review

 Nicholas Atkeson and Andrew Houghton, founding partners of Delta Investment Management, have written what, in the words of the lengthy subtitle, is a disciplined approach to building and protecting your wealth in the stock market by managing your risk. Win By Not Losing (McGraw-Hill, 2013) is a mix of stories about some not-so-famous investors (in fact, a few are identified simply by their first names) and an introduction to tactical investing.

The authors contend that “stock prices are influenced by oddities in human behavior that often cause security pricing to be predictable.” (p. 120) They support their contention by sharing some of their observations from the trading floor of an investment bank. Earnings momentum, for instance, can be both predictable and profitable: “the cycle of exceeding analysts’ estimates is often predictable in light of the pressures on analysts to be overly conservative.” (p. 121) And one study found that “over the 60 trading days after an earnings announcement, a long position in stocks with unexpected earnings in the highest decile, combined with a short position in stocks in the lowest decile, yields an annualized ‘abnormal’ return of about 25 percent before transaction costs.” (p. 122) (more…)

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