It would seem that risk (like love) is all around us – whether we’re crossing the road, catching a plane, or even making breakfast.
And to most of us sane folk, risk is something that we want to avoid – especially financially.
When I sat down at my desk this morning I pulled the dictionary from the shelf and looked up the meaning of the word “risk”.
“The possibility of incurring misfortune or loss.”
It definitely sounds like something I want to avoid.
And yet, as human beings we don’t wrap ourselves in cotton wool and hide behind the sofa – we evaluate risk and manage to avoid it. And this is something we do everyday of our lives, often without even being aware that we are doing it.
Most of these evaluations are quick and simple to make – we judge our distance from other cars on the motorway … we prod and sniff at the dubious piece of cheese found at the back of the fridge … each time, we’re assessing risk.
Getting to grips with risk in financial trading
When it comes to financial decisions, these risks aren’t usually so apparent, and the result of this is that many people take extreme approaches to financial risk that really don’t match up to how they view risk in other areas of life …
Investor “A” may take the “cotton wool” approach, burying all his funds in a safe investment, which makes a meagre return for him that won’t even match inflation (leaving a banker or fund manager to cream off the profits).
Meanwhile Investor “B” has gone the other way, and ploughs his entire investment fund into a high-risk venture that promises 100% returns within the next few months.
My hypothetical Investors A&B may seem extreme, but I’m constantly amazed by how many investors follow exactly these approaches, and how few find a measured middle ground.
The risk “blind spot”
If you look up “risk management” in an investment book, chances are that you’ll be told to risk no more than a small percentage of your fund on any one trade … to diversify across different markets and investment types … to avoid over-leveraging your account … and that, ultimately, we all have a different highly personal risk tolerance.
This is all very true, but you only have to watch five minutes of “Deal or No Deal” on daytime telly to see just what a dreadful grasp of risk tolerance the human brain has!
Most of us would view our outlook as “risk averse”, which means that we are willing to pay money to avoid risky ventures, even if the value of that venture is in our favour.
Let’s see how risk averse you really are …
Imagine you’re a contestant on a TV game show. You have just won £10,000. The host offers you a choice: you can quit now and keep the £10,000, or you can play again. There’s a 50% chance that you’ll win, and if you do win you’ll increase your £10,000 to £20,000.
Do you keep the £10,000 or do you play again?
If the answer is to keep the £10,000 (the risk-averse option), then what figure would tempt you to play again? £22,000 … £30,000 … £40,000 …?
When faced with these type of decisions, we realise how little we know and understand about our own personal risk tolerance.
And there’s another problem we run into with risk – we aren’t consistent with it.
Most people have a very different attitude to large risks compared with our attitude to small risks. If we were risking £100 for a 50/50 chance of making £200, we’d feel very differently about it than we do risking £10,000 for a 50/50 chance of making £20,000.
It all comes down to how valuable that £100 or £10,000 is to you as an individual – and that’s where the subjectivity comes in.
So, if we’ve established that we’re useless at evaluating our financial risk off-the-cuff, the only solution is to sit down and work it out the boring way – with pen and paper or an Excel spreadsheet.
When you do this, remember that trading the financial markets is not like that TV game show – you don’t have to squeeze all your trading into a 30-minute timeslot! Trading is a long game, and one of the most important things a trader needs are sufficient funds to continue trading, tomorrow, next week, next year ….
And that’s why we keep our risk percentages low – 1% on any one trade is plenty … 3% is pushing it.
Also remember that risk runs both ways – if you’ve got a trade that’s showing a healthy profit, that profit is at risk in the market. And if that profit represents too high a percentage of your trading fund – you could be breaking your risk rules by not protecting it.
I’ll be talking more about risk in future articles – with ideas for the careful balancing act we need to play with our risk-reward ratios.