Courtesy of Technical Traders
This article will most likely open your eyes and see a side of trading you usually don’t think about or possibly don’t understand, even though it is critical for your long term success as a trader and investor.
Not many people talk about trading risks and for a good reason. It’s not that exciting to most, and its a real sobering topic because its the reality of trading: trading is risky, and that you need to know how to manage risk appropriately and we don’t know how to do this. Most of us are generally too lazy to want to learn dry/boring subjects, especially when we don’t know much about them in the first place, and I’m guilty of this as well.
I urge you to take 4 minutes and read this trading risks explained in laymen terms below. At worst is a good refresher and will make you look at your current positions and see all your capital carries the same risk and if you are positioned for steady growth or potential account implosion if the asset class moves against you.
Understanding Trading and Investing Risk Types
RISK
noun 1.a situation involving exposure to danger: “flouting the law was too much of a risk” synonyms: possibility, chance, probability, likelihood, danger, … more antonyms: impossibility
verb 1.expose (someone or something valued) to danger, harm, or loss:
There are many ways to define risk and different, disparate types of risk depending on investing in a home, doing business with a bank or investing in stocks, bonds, ETF’s, mutual funds, etc.
We know inherently, given my last week’s piece on the increasing amount of foreclosures occurring in the largest cities in the US, where housing has been robust, cities like San Jose, CA, San Francisco, Phoenix, Chicago, etc, that there is currently increasing risk in purchasing real estate at lofty prices and hoping that the market stays hot; that if you had to resell the real estate in the next few years one could get out at a similar price to the purchase price or even higher.
Given that we are towards the end of a boom housing cycle, this is probably not a reasonable risk to take, unless of course, one would be in it for the long haul. We call this liquidity risk or also buying an asset at a very high price as compared to its historical prices in a given market.
Another risk is if an investor, flush with cash, sat in cash and inflation were to take off or the price of goods and services continue to increase even without rampant inflation. This risk would be defined as purchasing power risk and puts the investor (or holder of cash) in an undesirable position of having their money NOT grow while the cost of goods and services around them grows. This can and does occur even if we are told that inflation is flat.
How does purchasing power risk show up?
Look at the cost of food in the past few years. How much does it cost to feed a family today? When one has investable cash and does not keep it up with the increasing costs of “living,” this is the real definition of purchasing power risk.
If on the other hand, an investor decides to enter into the bond and stock market and invests in the wrong asset class, this is the best-known risk defined as asset class risk. One invests in the fixed income markets, and rates go up and while the coupon may stay the same the principal amount of the investment goes down.
Another potential risk asset class or even sector-specific risk is if someone decides to invest only in small-cap stocks because they like the growth rates, and this area of concentration is enticing. However, there is an inherent risk:
a) interest rates go up which puts pressure on smaller companies;
b) the economy goes into a downturn and these stocks lose value and
c) most importantly, they want to get out of these stocks at some point (perhaps due to a and b above) and they cannot get out at a fair price because too many people are selling and there is not enough volume in the stock.
Then the problem for the small-cap investor may be getting out of these thinly traded stocks when the correction ensues. This is known as liquidity risk and can have a detrimental effect on the original portfolio value.
Perhaps one decides to invest in stocks and decides to appropriately diversify their investment into a longer-term buy and hold strategy and does so with high quality, dividend-paying stocks. This seems like a reasonable investment thesis and one that both institutions and individuals participate in every day.
However, what happens when we go through normal corrections or even enter a bear market and have a steady trending downward market. What does one do? Buy more as the stocks are going down? Wait until they seemingly bottom and then put more $ to work? We call this market and price risk, and it is from having $ invested in a down-trending market with no clear plan of getting out and not being sure of what the targets are that one should exercise to get out.
Then, as an investor playing in a professional market, you always have knowledge risk and unforeseen surprise risk. Knowledge risk is not knowing the “full” story and investing in a company that you may know little about and what the forward earnings projections are. Some that come to mind in recent time is GE, XOM, BBY, JCP and many others that seemed like very good, quality companies only to announce reorganizations, problems with their business or worse, potential bankruptcy.
The unforeseen surprise element, while similar, includes accounting errors (WorldCom), corruption (ENRON), and other factors that an investor may have little to no knowledge of.
Other investors like to trade and invest where they have little or no knowledge in emerging markets like Russia, China or Brazil only to surprised when political upheaval, slowing economies, currency risk or other factors can and will hit these markets hard and decimate speculative investor capital.
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