Before you know,
I’ll be over the water
Like a swallow.
There’s no risk.
--Kate Bush

Chances are that when you consider buying a stock, your first question is similar to, "How much money can I make on this position?" However, sage money managers claim that the key to financial success is managing risk. So, your first question really should be, "How much can I lose?"

Effective market participants are aware of risk's meaning and of risk management strategies.

Risk = Potential for Loss

Which seems a riskier proposition for a $10,000 investment: (a) purchasing a six month certificate of deposit (CD) at current interest rates or (b) buying shares of Google (GOOG)? Choice (a) is likely less risky. Why? Well, in most situations you can count on getting your initial investment (a.k.a. 'principle') back plus interest on the CD as promised by the seller of the CD, while the rocket ship ride that has defined GOOG's share price since the company first went public in mid 2004 might suddenly end. Compared to the CD, the probability of losing money with an investment in GOOG seems significantly greater. 

A good working definition of risk is potential for loss.

Risk is not necessarily a bad thing. Indeed, the relationship between risk and reward has long been recognized (e.g., Knight, 1921). What's problematic, though, is that either through ignorance or emotional impediments, people often take on more risk than they should. In order to accumulate wealth, capital must be preserved. Stated another way, if you lose all your money, it's hard to stay in the game.

There are many strategies for managing risk. Most can be categorized as either (a) reducing correlation between investments or (b) actively controlling the degree of loss. In this article, I'll focus on how to reduce correlation between assets. Techniques for actively controlling losses will be the subject of another article.

Reducing Correlation Between Assets

Diversification. "Don't put all your eggs in one basket." Most of us have heard this saying, and the concept applies towards managing financial market risk. A classic example lies in the Enron story.



Chart courtesy of StockCharts.com

By now, Enron's case is familiar to many (for a summary, see McLean et al., 2001). What began as a natural gas distribution company grew into a firm ranked near the top of the Fortune 500. By the late 1990s many Enron employees eagerly allocated large amounts of their net worth, including the bulk of their retirement account assets, towards company stock. Enron's stock price ripped higher, and many shareholders saw their net worth (on paper) double or triple in a short period of time. By late 2000, however, the rocket ship ride was over and the now famous implosion of Enron's company and stock left many employees with little (or negative) net worth.

An isolated incident of employees making a concentrated bet on their company's share price? Hardly, as employees at many companies have similarly allocated large amounts of their wealth towards their company's stock. Arguably, the key difference between the concentrated bets of Enron employees and those of employees elsewhere is that the risk reflected in Enron employee bets was actually realized. A risk, when realized, becomes a loss.

One way to reduce risk is to 'spread the eggs around'--i.e., to diversify. Be careful, however. A portfolio of financial assets is not well diversified if prices of the holdings are highly correlated. Owning stock from various companies or market sectors does not necessarily make you well diversified, since prices of many stocks may move up and down together.

One of the most important diversification concepts is that a security's risk is not as important to an investor as the contribution that the security makes to the risk of the investor's entire portfolio (Markowitz, 1952). Assets that are less positively correlated, or perhaps even negatively correlated, are desirable from a diversification standpoint.

Effective diversification is often achieved by acquiring assets from different market categories. Prices of stocks and commodities such as gold, for example, often move in opposite directions (Rogers, 2004). Spreading capital among different asset categories is often referred to as asset allocation. Studies suggest that asset allocation is perhaps the most important determinant of long term investment returns (Swenson, 2000).

While it can be useful to observe the portfolios of other investors and observe their asset allocation choices, it is rarely advisable to blindly copy the decisions of others. Risk management strategy varies for each individual, and depends on many factors including:

• Financial goals
• View of the world
• Risk tolerance
• Time horizon
• Portfolio value
• Capacity for monitoring the financial environment

Funds that mirror index or sector performance can be an economical way to diversify. Increasingly popular vehicles for gaining such exposure are exchange traded funds (ETFs). In 2006, ETF assets under management topped $450 billion in the US alone, and are being utilized by both individuals and professionals seeking to diversify in a manner that produces attractive returns (Bianco, 2007). Unlike mutual funds, ETFs trade intraday on major stock exchanges which makes them attractive from a liquidity standpoint; they also tend to have lower expense ratios than most mutual funds (Mazzilli, Maister & Khan, 2007). Two of the largest ETFs by daily volume are S&P Depository Receipts, also known as 'Spyders' (SPY), and Nasdaq 100 Tracking Shares (QQQQ).

Some believe that many individuals are over-invested in stocks and taking too much risk. Indeed, risky asset allocation strategies often seem embedded in fiduciary policies.

Diversification requires careful thought because too much diversification can dilute returns while too little diversification can be disastrous. The key is finding a level of diversification that reflects a 'risk profile' that works for you.

Hedging. Hedging involves reducing risk in a particular position by making an offsetting or counterbalancing bet. When you think about it, hedging seems similar to the diversification concept noted above. It is, but hedging is often associated with managing risk over a shorter time horizon. Traders commonly employ hedging, often by paring long and short positions, as a means for managing risk in the ebb and flow of daily market price movement. Use of this technique, by the way, is how hedge funds got their name (Steinhardt, 2001). Hedging helps manage risk--particularly with respect to extreme losses.

Final Comment

To forecast the degree of diversification that a particular portfolio would provide, investors usually examine historical correlations between financial assets, such as the SPX: gold relationship shown above. The assumption is that historical correlations will likely continue into the future. This is assumption is not always accurate, however, because correlations between assets can change from one period to the next depending on a variety of factors. The implication is that investors need to monitor actual correlations between their portfolio holdings to determine whether they are actually achieving the desired level of diversification.

Risk management begins by asking "How much can I lose?" before considering the rewards. Diversification is one way to prudently manage risk.

References

Bianco, A. (2007). Outsmarting the market. Business Week, January 22: 59-63.

Knight, F.H. (1921). Risk, uncertainty, and profit. New York: Harper & Row.

Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7: 77-91.

Mazzilli, P., Maister, D. & Khan, A. (2007). ETF: Overview and strategies. New York: Morgan Stanley Research.

McLean, B., Varchaver, N., Helyar, J., Revell, J. & Sung, J. (2001). Why Enron went bust. Fortune, December 24: 52-59.

Rogers, J. (2004). Hot commodities. New York: Random House.

Steinhardt, M. (2001). No bull: My life in and out of the markets. New York: Wiley.

Swenson, D.F. (2000). Pioneering portfolio management. New York: The Free Press.