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How Much Risk Should I Take?

How Much Risk Should I Take?

If you read technical analysis reports or any kind of possible “predictive” analysis reports on markets performance – if they have a commercial angle – you will often read the statement “past performances do not guarantee future performances“. This is obviously an important disclaimer that whoever is selling must include in any literature going out to clients.

As an investor or a trader acting on behalf of a client, this leads us to an important question at any given time: how much risk should I take? This topic has been discussed endlessly and there are great articles on the web written by several gurus on the subject. I recommend the following articles:

It has been noted that what people tend to do is to benchmark their portfolios against reference indices for example, and display the historical data on a plotted chart. Ideally, portfolio managers want to exceed their benchmarks. But this also serves as a buoy in case of an under performing portfolio, when the benchmark is performing worse than the portfolio. Technical projections will show us, based on historical data and logical projections, information such as bearish or bullish potential, possible prices movements/divergences and market cycle considerations, among other relevant information.

Statement “past performances do not guarantee future performances” goes hand to hand with the fact that technical analysis, while a great discipline that no doubt helps investors and traders to sustain their views, is based on historical data. The problem with this approach is that there is no guarantee that past events will replicate in the future (this fact also applies to certain risk measures such as VaR).

It’s never too much to revisit Warren Buffet’s rules 3 timeless investing principles, which are solidified on Graham’s teachings:

Principle 1: Always Invest with a Margin of Safety

Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham’s goal was to buy assets worth $1 for 50 cents. He did this very, very well.


Principle #2: Expect Volatility and Profit from It

Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of “Mr. Market,” the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business’s prospects and quotes a low price.


Principle #3: Know What Kind of Investor You Are

Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active Vs. Passive

Graham referred to active and passive investors as “enterprising investors” and “defensive investors.”
You only have two real choices: The first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn’t your cup of tea, then be content to get a passive ( possibly lower) return but with much less time and work. Graham turned the academic notion of “risk = return” on its head. For him, “Work = Return.” The more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return – for example, equaling the return of the S&P 500 – is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it’s so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market’s return and avoids doing worse than average by just letting the stock market’s overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don’t beat the market.

Speculator Vs. Investor

Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing – just be sure you understand which you are good at.

At the end of the day, it’s up to the investor or trader to decide either to go defensive or take on risk. The decision of how much risk an Investor or trader should take must be based on very sound fundamentals. For us, Warren Buffet is our reference investor, who is worldwide considered the greatest investor of all times. Warren Buffet is also related to who was considered the father of security analysis and value investing – Benjamin Graham, who was Buffet’s teacher, mentor and friend.

We believe that most investors or traders must own of have read Intelligent Investor: The Definitive Book on Value Investing – A Book of Practical Counsel.

Please remember: “past performances do not guarantee future performances

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Antonio Caldas

Program/Project/Risk manager with 15+ years mix-industry, with a particular emphasis in Banking & Financial Services. Active in risk management, market risk control, front office risk management, product control, change and transformation management, business analysis and business process improvement for global capital markets and investment banking, covering a multiple range of asset classes.

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