The Finance Professor
The Finance Professor: Manage Risk Like a Pro
Scott Rothbort
06/15/07 - 04:04 PM EDT
Recently, I discussed the concept of risk. Now that you understand the main forms of risk that you might encounter, I want to take the discussion one step further and focus on risk management. Risk management is the process by which risk is identified, quantified, and controlled (as much as possible).
Get Organized and Identify Your Risks
Risk management starts by identifying the risks that are embedded in individual holdings and at the portfolio 
level. This starts by having a good accounting and organization system for your holdings. I suggest developing a database that allows you to organize, query and manipulate data in an expedient manner. Make sure that this database separates or identifies your holdings by asset class . For example, have a field that indicates whether a holding is a stock , option , bond , preferred stock or other type of security. Include other fields for such information as position, rates, dividends , maturities and expirations . The more characteristics in the database for an individual security, the better your chance of identifying, quantifying and managing risk.
Once your database is on track, you'll need to develop a disciplined and proactive approach to populating and updating it. When you add a new asset or security to your portfolio, you should immediately update the database and recognize the risks inherent in holding that particular investment.
Quantify Your Risks
With a convenient database of your holdings, the next step is to quantify your risk. This can be done by first sorting the data into different asset classes, which typically have unique risks associated with their asset types. Then you can begin to apply some quantitative measures.
For example, you may want to calculate the market risk for your portfolio. Here is a question taken directly from an exam for my MBA students at Seton Hall University:
You own the following portfolio:
| Your Stock Portfolio | ||||||
| Stock | Shares | Price | Beta | Dividend | ||
| Caterpillar (CAT) | 10,000 | $74 | 1.05 | 2% | ||
| Google (GOOG) | 2,200 | $400 | 1.50 | 0% | ||
| Southern (SO) | 20,000 | $30 | 0.45 | 5% | ||
| Men's Wearhouse (MW) | $7,000 | $40 | 0.90 | 1% | ||
for each stock and then add together the products.
With this portfolio, that would be:
of the bond portfolio. Duration is a measure of risk for a bond that gauges the average maturity for the payment of all bond cash flows. Changes in interest rates will then impact the pricing of a bond based on its average duration. What's important to note is that the longer the duration of a bond or portfolio, the more risk that bond or portfolio of bonds will carry. Thus, a 1% change in a bond portfolio with a three-year duration will have less impact on the portfolio than that of a seven-year duration portfolio.
Set Controls
Risk is managed by understanding the its impact on the portfolio. It is a game of targeting cause and effect. Let's not forget that without risk, there is no reward. So you have to go back to the basic question: How much am I willing to risk to achieve my desired return ? Once you have answered this question, you can use a stop order to manage the risk.
is an effective trading technique to limit losses on a stock. A stop order is an order you place with your brokerage that's executes a market order once a stock falls to a predetermined stop level (see stop price ).
For example, let's say you bought Google(GOOG Quote) at $500 per share, and your research indicates that Google can get to $600. However, you want to be able to cut your losses should the stock drop, let's say, 10% to $450. So you place a stop order (it can be a day order or good-till-canceled order ) to sell Google at $450.
Another version of a stop order is called a stop-limit order (or stop-loss order). Here, a stop order is triggered, but instead of a market order being initiated, a limit order at a limit price is then placed for your account.
Sometimes I use "hard" stops and enter actual stop orders. However, most of the time I use "soft" (or mental) stops, which means that when a stock drops a certain percentage, I closely re-examine my position and determine if my original thesis for buying the stock was incorrect. If so, I then sell the stock. However, if the stock is down due to a weak market or a motivated (read: panicked) seller, then I stick it out and hold for better prices.
More-sophisticated trading techniques to manage risk include hedging with derivatives and pairing by short-selling a comparable stock. I'll cover these in more depth in another installment.
trades with LTCM. LTCM wanted to do a "risk arbitrage " swap on Tellabs' (TLAB Quote) acquisition of Ciena (CIEN Quote). I knew the deal was going to go bust because for all of LTCM's Nobel Prizes and doctorates, it simply had no idea what it was getting into.
To make a long story short, I refused to do the deal and stood my ground, and two weeks later the Tellabs/Ciena merger was canceled. Several weeks later, LTCM went belly up.
I was able to identify that LTCM did not fully understand the risks involved with the contemplated transaction. As a trader responsible for protecting my employer's capital, I was also acting in a risk-management capacity, because I would have been exposed to credit risk if I'd taken the other side of the swap from LTCM. LTCM did not understand the trade, but I did and thus prevented the fund from making a big mistake.