Portfolio managers talk about risk not in terms of loss but in terms of variability of their returns. This way of looking at risk can also be valuable to stock traders.
Jesse Livermore, one of the world’s most famous speculators, was known for plunging – risking all of his available assets plus a large margin from his brokers in single trades. In addition to making fortunes, he lost them too. Although Livermore’s trading tactics are as relevant today as when he used them, his management of risk often left much to be desired.
Risk
You take a risk every time you drive to work or cross the street. You take a risk when you dine out. You take a risk when you trade shares hoping to get rich.
What Does Risk Mean?
Each example above describes an action you take to get something you want. However, there is also the possibility of an outcome you don’t want – be that serious injury in a car accident, food poisoning in a restaurant or losing money in your stock-trading activities.
To trade stocks successfully, you need to understand risk.
To professional portfolio managers, a high-risk portfolio is one in which the returns are highly variable.
For example, here are the five-year track records of two stock portfolios:
| Portfolio | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
| Portfolio A | – 20% | +100% | +76% | -10% | +50% |
| Portfolio B | +5% | +8% | +4% | +7% | +6% |
Portfolio A Performance Summary
- Average Annual Return +39%
- Annual Compounding Rate +31%
Portfolio B Performance Summary
- Average Annual Return +6%
- Annual Compounding Rate +6%
Portfolio A, compounding at an average rate of +39% per annum, would be described as high risk, because the annual rate of return is highly variable.
Portfolio B, compounding at an average rate of +6% per annum would be described as low risk, because the annual rate of return changes little from year to year.
The portfolio manager’s definition of risk seems to be lacking because it fails to see the ‘risk’ that your rate of return is lower than you expected. There is a high ‘risk’ that you will not grow wealthy with Portfolio B.
On the other hand, how many of us would have the nerve stick with a portfolio (or a trading method) like A, that lost 20% of our funds in its first year? To that extent, we can sympathize with the portfolio manager’s definition of risk.
To further examine this definition of risk, which trading strategy would you rather follow from the two below? Which of the two would you be most likely to stick with after sitting down after the first year and reviewing your performance? Be honest now!
| Portfolio | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
| Trading Strategy A | – 20% | +100% | +76% | -10% | +50% |
| Trading Strategy B | +25% | +35% | +25% | +30% | +39% |
Results: $100,000 allocated to A will grow into $380,160 while $100,000 allocated to B will grow into $381,164.
Traders following strategy B would sleep more easily at night than those following A. Furthermore, many beginning traders using Strategy A would give up after their first year, believing their trading skills to be poor, even though Strategy A would reward them handsomely over a longer period of time.
For this reason, when you are choosing your first trading strategy, it’s important to consider variability of return. When you are testing strategies, you should select those which offer good profits AND have low variability in yield. This will allow you to build confidence in your methods. Later, you may be happy to accept higher volatility in pursuit of higher returns.