Investing Tools for Investors Looking to Excel
10/21/02  

 Assessing and Dealing with Risk

It is important to understand risk and how much of it you are assuming in attempting to achieve your investment objectives. First, there is elemental risk. This is what you fear when you cannot sleep, or are completely distracted by a sense of imminent doom. This is palpable and should not be tolerated. You need to put your finger on the issues and ameliorate the condition by raising cash, reducing concentration, etc. Keep in mind, however, there is risk in being under invested or not in sufficiently high beta stocks if the market does rise.

 Now let's talk about quantifiable risks.

Beta- This refers to how a stock moves vs. the market. If a stock moves more than the market, it has a high beta. If it moves little vs. the market it has a low beta. Technology generally has a high beta while Utilities have low betas. A portfolio of high beta stocks in a down market can create extreme downward movements, while up-markets can cause tremendous performance. If a market is demonstrating extreme risk, it is wise to raise cash, lower the beta of your portfolio, and even consider some hedging of exposure.

Valuation- This risk essentially deals with fundamental tools for determining fair value and the extent to which a stock is over or under valued. For instance, you would look at Price/Earnings, Price/Cash Flow, Price/Sales and P/E ratio to sustainable growth of earnings. Looking at these ratios in a vacuum is useless. Therefore, these ratios should be assessed against comparable ratios for the industry, the range of such ratios for the company itself, and the range of such ratios for the market as whole.

Technical Risk- This risk relates to various technical indicators, such as de-trending oscillators, Bollinger Bands, and simple observations of the extent to which a stock or market is trading above or below trend-lines and moving averages. If a stock is extended and approaching imminent overhead supply, it has risk of a pull-back to support.  Stocks in long term downtrends

Economic Risk- This is the risk associated with economic timing. Here, an investor assesses the extent to which the economy is growing or accelerating its pace of growth or the reverse. The are winners and losers under these various scenarios. The portfolio of cyclical stocks as the economy decelerates or faces imminent Fed Reserve rate increases may be hurt. See Economic Timing section for a more detailed discussion.

Extreme Market Risk- This involves valuation, technical conditions, economic issues, as well as sentiment. A market that is cheap by historical standards and other alternatives, that is technically oversold, and that is slowing with prospects of Federal Reserve rate decreases, may be ready to rally, particularly if investor sentiment is wildly negative.

Time Period and Nature of Risk- Risk is relative. There is short term, intermediate, and long-term risk. Short term risk may apply to days or weeks, and represent only a countertrend pullback of 1% to 7%. Intermediate risk may apply to weeks to months and may involve higher levels of risk. Finally, long-term risk normally occurs after a stock is technically broken and could last for years.

Actions

Too much risk can be ameliorated by raising cash, reallocating to lower betas, buying less extended stocks, or barbelling your portfolio with a balance of value stocks and higher betas.

Additionally, reducing inordinate industry concentration back to more normal weightings can lower risk.

Disclaimer

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