Author: Julia Lee
The idea of risk management seems to be a world away from the exciting world of fast and furious trading on the sharemarket. But some believe risk management is the heart and soul of wealth creation when dealing with sharemarkets.
In essence, risk management is all about understanding when to seize opportunities and when to let go of what could be bad investments.
Without risk management, there would be countless lives which would be impacted. The insurance industry as we know it would not exist. Without risk management, there would be no space travel, medicines available would be very different from what we have now and business would look very different.
Heads you win, tails you win
It's all about getting probabilities tipped in your favour. Think about a game of heads or tails. The chance of landing either is 50/50. What about the sharemarket?
Study by Roeichensten and Dorsett over the S&P 500 from 1926 to 1993 showed that uncertainty about returns was smaller in the longer-term compared with the short-term. It seems that in the short-term the market is more akin to a casino but in the long-term the odds are stacked in an investor's favour.
Which reminds me of a famous quote by Warren Buffett: "In the short run, the market is a voting machine; in the long run, it's a weighing machine."
Outliers and black swans
A story on risk would not be complete without talking about outliers.
Outliers in sharetrading are often now called 'black swans'. This reference comes from the 2007 book titled 'The Black Swan' by Lebanese scholar Nassim Nicholas Taleb. In the old world, swans were thought to only be white. It was only in 1697 when black swans were discovered by a Dutch expedition that people realised swans were not only white.
In the same way, there are events which may seem outside the realm of probability. When they occur, they have a major impact and after the event it is rationalised by the market.
The point is that these black swans are more common than is perceived and by forming a plan to deal with these black swans, investors can deal with these events more successfully.
Deviate from the norm
Peter Bernstein in his book 'Against the Gods: the Remarkable Story of Risk' says that much risk taking rests on opportunities that develop from deviations from the norm.
Indeed it seems as though successful investors have capitalised from moving against the crowd. Whether you look at Warren Buffett or Benjamin Graham, the sharemarket seems to be an illogical beast in which business-minded people have identified great opportunities that arise from these deviations from normal.
It's about your behaviour
Risk is also about behaviour.
"Fear or harm ought to be proportional not merely to the gravity of the harm, but also to the probability of the event" (logic believed to have been written by Antoine Arnauld).
But try telling that to a swimmer with a fear of sharks on a day after a shark attack has occurred. Or to a person that is scared to fly!
We are shaped by our individual fears and so risk managementshould also be different for everyone.
So while risk management often sees people respond with a yawn, by understanding the odds, traders can make plans about what to do about the future. Successful sharetrading requires successful risk management and that includes understanding the sharemarket risks and your own behaviour.
About the Author
Julia Lee is an Equities Analyst for online share trading platform Bell Direct. Julia provides information on share trading and online trading for frequent traders and investors.