When it comes to active investment in the stock market, the concept of Risk Management is about controlling the amount of capital that may be lost in the event that the market or a stock turns against your open positions. This week we will carry on from where we left last week’s post on Risk Management and Money Management to take a look closer at general Investment Risk in the market. This material has been extracted from the SPA3 reference manual for your learning.
Definition of Investment Risk: the downside potential of open positions in the market.
Investment Risk can be broken down into two kinds of risk that could cause downside potential: market risk and specific risk. Market risk is the risk that arises from general overall market movements. Specific risk arises from events that are specific to a particular listed company or a group of companies in the market, such as an industry sector.
Modern Portfolio Theory (MPT) teaches diversification as the method to use to minimise (since elimination is impossible) investment risk. MPT contends that specific risk cannot be controlled because there are too many factors that influence specific risk and because price action in the market is random. MPT assumes that matching the performance of the overall market index is acceptable in return for minimising market risk in investment portfolios through diversification.
There are four shortcomings with this thinking. Firstly, MPT assumes that large portions (30% – 50%) or entire portfolios cannot be withdrawn from the market in a short time span (a few days). Secondly, the return that the index provides might not be good enough for active investors!! Thirdly, MPT may not have researched the scenario of creating a portfolio where entering and exiting positions in the market is done according to a consistent methodology that has integrated timing, risk management and money management rules. Fourthly, all stocks tend to have a high correlation during bear markets meaning that diversification is limited in reducing drawdown to less than that of the overall market.
The foundation for MPT is the belief that price action in the market is totally random. SPA3, or any successful trading methodology, proves that biases do exist and that trends start and stop following certain price action patterns in the market.
Passive investors may find the MPT approach acceptable – until they invest in gaining some advanced active investment knowledge.
Active investors who use technical analysis to invest in the market do so understanding the following:
- The price action of a stock discounts everything known and unknown about that stock and ultimately measures sentiment of the participants regarding the stock. Sentiment creates the supply and demand that determines the direction and the variability of the share price.
- Biases exist in the market that can be captured and exploited using technical analysis to determine price entry and exit points.
Using certain tools, strategies and methodologies based on price action it is, therefore, possible to assess your risk in the market and take appropriate action to control that risk. Using these methodologies, it is possible for active investors to achieve returns far in excess of the overall market index.
Knowing how to manage risk requires you to firstly be able to recognise the risk and then assess that risk applying the appropriate risk controls that we will discuss in next week’s post.