Posts Tagged ‘risk’

Government intervention leading to more risk for banks?

Tuesday, December 23rd, 2008

Back in How do you define risk?, we wrote,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is.

Also, as we wrote in Real economy suffers while financial markets stuff around with prices,

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinder long-term planning.

Paradoxically, government interventions, for all their good intentions, are making the situation worse by introducing unintended consequences into the global financial system. For example, in the case for banks, Satyajit Das wrote in Fear & Loathing in Financial Products: Banks – The ?V?, ?U? or ?L?,

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Everything else being equal, the increase in the amount of capital needed implies a reduced availability and amount of credit to the real economy. This in turn will have an effect on economic activity.

Is it time to buy stocks in times of intense fear and volatility? Part 2: Leverage position

Tuesday, October 28th, 2008

Today, we will continue from Is it time to buy stocks in times of intense fear and volatility? Part 1: Introduction. The question was:

Surely, some of these stocks are undervalued by now right? Should you buy now? Even Warren Buffett is buying.

Well, the answer will depend on your personal circumstances. More specifically, it depends on your current level of leverage.

Before we continue, we must stress again that anything on this publication should NOT be considered as personal financial advice. We are approaching the above posed question from a philosophical point of view. Thus, we will be making many assumptions, generalisations and simplifications. The point of this article is to provoke you to think about your investment decisions based on risk-reward probabilities and should not be seen as some kind of economic analysis/prediction. Now, let get back to the gist of the article…

Let’s look at one extreme scenario. Suppose you are currently very highly leveraged. Also, you are not sure what the long-term economic outcome will be. Will the future pan out to be a V, U or L shape recession (see What type of recession is coming?)? But you believe that a V-shape recession is unlikely. Between the U or L shape recession, you are not sure which one will turn out. Now, let’s work out your risk-reward outcomes for each scenario:

  • V-shape recession (unlikely): You will stand to gain immensely when the economy bounces back ‘soon.’
  • U-shape recession (more likely): You will suffer some losses for an extended period of time. But eventually, you will recover and gain.
  • L-shape recession (not so likely but possible): You will lose your entire life-savings, go bankrupt, lose your home and become destitute because of your high leverage (e.g. someone using their mortgaged home as collateral for their stock market investments).

Now, let’s suppose you are at the opposite extreme: complete absence of leverage (i.e. 100% in cash). Let’s look at your risk-reward outcomes:

  • V-shape recession (unlikely): You gain and lose nothing when the economy bounce back ‘soon.’ Relative to the highly leveraged investors, you are very much worse off.
  • U-shape recession (more likely): Compared to the very highly leveraged investors, you are better off during the downturn. Eventually when the economy recovers, you will not be too much worse off than the highly leveraged investors either.
  • L-shape recession (not so likely but possible): You will be way ahead of the highly leveraged investors.

As you look at these two scenarios, it becomes clear that for the very highly leveraged investors, they will sleep much better at night by reducing risk of catastrophic loss through the reduction of potential for gain. That means de-leveraging. For the completely un-leveraged investors (maybe a person who is 100% in cash should not be called an investor?), they increase their prospect for gain (without increasing the prospect of disaster significantly) through increasing their risk of loss. In other words, for the cashed-up investor, the reward outweighs the risks.

In today’s free-falling market conditions, it is clear that the majority of investors are de-leveraging because they want to reduce their risk. Contrarian investors should be approaching the market from the position of extremely low risk seeking towards a gradual and measured increase of risks.

What if you are one of these contrarian investors seeking to increase your risk in the stock market? Which stocks to pick? Keep in tune!

Is the value of an asset its price?

Wednesday, July 2nd, 2008

Continuing from our previous article, Difference between ?assets? and real assets, we will discuss two concepts that are often confused with each other- price and value.

Everyone knows about price. So, we will not talk more about it. But the trick question is: is the value of an asset based on its price? In accounting, the value of an accounting asset (as opposed to the definition of an asset that we mentioned in Difference between ?assets? and real assets) is based on price, whether historical price of some kind of derivative of market price. In today’s speculative mindset, the quality of our investing endeavours is often judged according to the price it can fetch on the market. For example, the 2007-2008 financial year was marked by abysmal ‘performance’ of the stock market, which implies abysmal performance of our superannuation funds. Basically, this means that the price of stocks have fallen. In this kind of herd mentality, it is often easy to associate price with value.

But as investors, we have to understand that there is a difference between price and value. The former is just an easily understood nominal number. Value, on the other hand, is a relative concept. The value of something implies its worth relative to something else. So, what is the value of an asset? As we explained before in Difference between ?assets? and real assets, an asset is something that

… puts money into your pocket periodically.

Therefore, the value of an asset is a measure of the worth of its cash flow relative to the cash flow of something else. What is the “something else” that an asset’s value is compared against? Well, it is the cash flow fetched by a long-term government bond. In other words, the cash flow of the long-term government bond is used as a yardstick for which we measure the value of an asset’s cash flow.

Government bonds are theoretically zero risk in nominal terms (not in real terms though) because it cannot default on its loan (well, not if the government happens to the Russian government in 1998) as it has the power of the monetary printing press.

The cash flow of an asset, on the other hand is full of risks compared to the long-term government bond. Behind an asset is always a business enterprise, which can fail in its ability to earn cash to its owners’ satisfaction- the business may even fail completely. Therefore, to compensate its owners of that higher risk, it has to earn a return higher than the risk-free government bond. The riskier the business enterprise is, the higher the rate of return should be demanded.

In the next article, we will explain what the return on an investment is. That will involve more mathematics.

How the folks in the finance industry got the idea of ?risk? wrong!

Wednesday, January 17th, 2007

In our previous article, How do you define risk?, we put forth our criticism on the way risk is measured by many in the financial service industry. Today, we will look at the underlying theory behind their measurement of risk. The recommended reading for today will be How the Finance Gurus Get Risk All Wrong.

As you may have noticed, ?risk? is often expressed as a nice and simple number in the world of finance. For example, in many stock research publications, the ?risk? of a stock may be defined in terms of a number called the beta. You may see risk jargons like standard deviation, the Sharpe ratio, variance, correlation, alpha, value at risk and so on. All these mathematical definitions of ?risk? give it a scientific feel, which seem to give us the impression that ?risk? can be measured and controlled. Unfortunately, in reality, these definitions and measurements of ?risk? are pseudo-science. The reason is because the underlying theory behind all of them is flawed in the first place.

What are the assumptions behind these conventional measures of ?risk?? They are all based on the assumption that price follows a statistic device known as the normal distribution. If a stock price follows a normal distribution, it means that at any given day, there is a 50% chance that it will go up and a 50% chance that it will go down by the same amount on average. In the long run, the vast majority of stocks? price will hover around its average, with a smaller percentage deviating from it. In other words, the behaviour of stocks? price will follow a bell curve like this (horizontal axis?stock price, vertical axis?probability of the price being at that level):

Bell curve

Is this a valid assumption?We doubt so. As you can see for yourself in the real market, prices often do not follow such behaviour?frequently, they move in trends and at times, exhibit extreme behaviour. As the article in the suggested reading (How the Finance Gurus Get Risk All Wrong) said,

The inapplicability of the bell curve has long been established, yet close to 100,000 MBA students a year in the U.S. alone are taught to use it to understand financial markets.

Thus, as contrarians, this is not the way we define risk.

How not to use options

Friday, January 5th, 2007

Many people have the impression that options are ?risky? because they expire after a cut-off date. Though this impression is understandable, it indicates a misunderstanding on the use of options. As a result, options are often misused, resulting in losses?that is where its bad reputation comes from.

To elaborate on how options are misused, we first look at how people trade stocks. It is easy to understand how to profit from stock trading?buy low and sell high if you believe that the stock price will rise. If you believe that the stock price will fall, you can short-sell?borrow stocks at high price, sell and then buy back the stocks at lower price later to return the loaned stocks. In other words, to profit from stock trading, you only have to get the direction of the stock movement right (though not exactly so for short-selling, but the idea is there).

Now, when you extend this idea to options trading, it becomes a recipe for losing money. Since options have expiry dates after which it becomes worthless, getting the direction right is not enough?you have to get the speed of the stock movement right as well. Since it is hard enough to get the stock?s direction right, let alone its speed, using options as if it is a proxy for stocks will result in increase likelihood of suffering losses. Also, options prices also depend on other variables in addition to the direction of its underlying stocks (the stock that the options derive from). In real life trading , it means that in some cases, it is possible for an option?s price to fall even though the underlying stock price remained unchanged.

Thus, if you are intending to trade options the way you trade stocks, we urge you to think twice. To trade in options, you need a paradigm shift from your understanding of conventional stock trading. We will touch more on that later. For more information on how to trade options safely, we recommend the books in the Derivatives section of Recommend Books.

How do you define risk?

Monday, December 18th, 2006

The answer to this question depends on whether you are investing from the retail level or investing along with the legendary investors of excellence.

First, let?s look at the former case. In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time. Since volatility does not engender the feeling of safety and confidence, it is to be avoided as risk wherever possible. The root motivation of this kind of perception is fear?the fear of losing it all. To assuage such fears, the financial services industry came up with ideas like portfolio management and asset allocation, in which their aim is to structure investment portfolios for the purpose of ‘controlling’ volatility, and thus risk, for a given return. However, in truth, no one can control volatility as much as the thermometer controls the weather. The best that can be done is to reduce the effects of volatility using past volatility behaviour as a guide.

Now, if you want to achieve results of excellence in your investment endeavour, you have to see risk differently. As contrarians, we define risk in terms of the soundness of the underlying economic and financial state. This implies that in order to understand the risk of an investment, we have to really understand the fundamental nature of the investment itself. Thus, if we invest according to our understanding of the economic and financial soundness of the investment, we should not let its short-term volatility perturb us.

To further illustrate today?s point, look at our views on gold. For this year, the gold price had been very volatile. Thus, compared with cash, the mainstream would see that gold is more ?risky? than cash. But in reality, if you understand the nature of today?s monetary system and economic reality, you will see that cash is in fact far more risky.

Hence, know your stuff.