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 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
For example, have a field that indicates whether a holding is a
preferred stock or other type of security. Include other fields for such information as position, rates,
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
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:
Now, how would you hedge your portfolio's risk?
The first step in answering that question is to determine how much risk is inherent in the portfolio. To do this, multiply the share position by price by
beta for each stock and then add together the products.
With this portfolio, that would be:
CAT: 10,000 x 74 x 1.05 = $777,000
GOOG: 2,200 x 400 x 1.50 = $1,320,000
SO: 20,000 x 30 x .45 = $270,000
MW: 7,000 x 40 x .90 = $252,000
Total Risk: $2,619,000
Thus, you have risk of $2,619,000 relative to the
. If the SPX were to increase by 1%, your expected portfolio gain would be $26,190
If you were using bonds, you would have to look at the
duration 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.
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
to manage the risk.
stop order 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
For example, let's say you bought
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
short-selling a comparable stock. I'll cover these in more depth in another installment.
Accept the Risk That You Understand
When it comes to taking risk, you have to accept risk that you understand. For example, as smart as Long-Term Capital Management was, I knew the end was near when the hedge fund started to expand into markets and strategies in which they had little or no experience or knowledge.
I dealt with LTCM from the day it started to operate. At the time, as the head of Global Equity Swaps at
, I was on the other side of many
swap trades with LTCM. LTCM wanted to do a "risk
arbitrage" swap on
. 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.
At the time of publication, Rothbort was long CAT, GOOG, MW, SO, and SPY and long with calls on MER, although positions can change at any time. Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University. For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.