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Types of Investment Risk

This week we move back onto the subject of “Investment Risk” and specifically the different “Types of investment risk”.

As mentioned below in my 6th October 2010 post, there are two main types of risk, market risk and specific risk.

Market risk is the downside potential that relates to the entire market or the industry to which the stock belongs.

Specific risk is the downside potential that relates to an individual stock. The downside potential could be caused by any of the following:

  • Market sentiment towards the particular stock.
  • The lack of sufficient liquidity in the issued shares of the company.
  • Shock announcements by or about a listed company.

Using technical analysis tools all the risks can be assessed and managed except for company risk, which includes shock announcements by or about a company that causes immense downside sentiment on the share price. An excellent example of this is ASX listed Biota in 1999 when approval for testing of their influenza drug was denied by the USA authorities and the Biota stock price dropped by nearly 50% over 2 days. Another good example is ASX listed AMP’s announcement to the market on 1 May, 2003 which caused the stock price to tumble by approximately 35% when the stock came out of suspension 2 days later.

There are plenty of similar examples in all stock exchanges around the world.

Managing Investment Risk

The potential return of various trades can be impacted by market risk and specific risk. The two main controls that you need to have in place to manage these risks are:

  • A finite, structured and unambiguous exit strategy through a Technical Exit Signal or a Stop Loss (Risk Management).
  • Allocating appropriate capital:
  • for investing in the market based on risk assessment and,
  • to a trade, both at entry and during the course of the trade, based on risk assessment (Money Management).

Exit signals and rules will ultimately determine the relative size of profit trades to the size of loss trades. Winning exit strategies obviously require that profit trades are relatively larger than loss trades, e.g. profit trades average 25% and loss trades average 10%. However, entry and exit strategies alone will NOT determine overall whether an active investor will make or lose money in a managed portfolio. Money Management is required to complete the picture.

The Money Management controls, relate to allocation of capital to individual trades. A simple example for the less-experienced is if a 25% profit trade is allocated $8,000 and a separate 10% loss trade is allocated $30,000, then the active investor will actually lose $1,000 between the two trades, despite having a larger percentage profit trade than the loss trade.

Money management will not turn a losing entry and exit strategy into a winning one but bad money management could turn a winning strategy into a losing one. Equally, good money management can make a good strategy even better, So a solid partnership between your entry and exit strategy and your money management is required to succeed as a trader or investor.

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