Change the phrasing from trading to speculating to be more pointed.
Add more and better criteria to what an investor does.
Added the entire section “What To Do”
Added a picture and more links.? Corrected grammar in a few spots and tightened up some language.
The main reason to edit this article as I did was to give readers more disciplined ideas with respect to buying and selling, and encourage them have rules, and keep a journal of decisions, together with why they bought, and at what point would they sell.? If not, then investors will not take losses when they ought to, and not sell when their thesis is proven false.? That is the way of more and deeper losses.
This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple. ?Today’s topic is:
What is risk?
Here is my simple definition of risk:
Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on?how much?it?missed the goals.
There are several good things about this definition:
Note that the word “money” is not mentioned. ?As such, it can cover a wide number of situations.
It is individual. ?The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation. ?The same event may happen for two people — it may be a miss for one, and not for the other one.
It catches both aspects of risk — likelihood of a bad event, and degree of harm from?how badly the goal was missed.
It takes into account the possibility that there are many goals that must be met.
It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus. ?Erudite, but bogus.
It doesn’t specify that there has to be a single time horizon, or any time horizon.
It doesn’t specify a method for analysis. ?That should vary by the situation being analyzed.
But this is a blog on finance and investing risk, so now I will focus on that large class of situations.
What is Financial Risk?
Here are some things that financial risk can be:
You don’t get to retire when you want to, or, your retirement is not as nice as you might like
One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
You can’t buy the home/auto/etc. of your choice.
A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
The firm you work for goes broke, or gets competed into an also-ran.
You lose your job, can’t find another job?as good, and you default on important regular bills as a result. ?The same applies to people who run their own business.
Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them. ?This can be harmful not just to the?banks and shadow banks, but to the economy as a whole.
Let’s use retirement as an example of how to analyze financial risk. ?I have a series of articles that I have written on the topic based on the idea of the?personal required investment earnings rate [PRIER]. ?PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.
The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals. ?From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:
To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].
I?m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.? There?s a reason for this, and I?ll get to that later.? Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.
Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.? (Today that would be higher than 9%.)? That means you are not likely to make your goals.?? You can either:
Save more, or,
Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.
Those are hard choices, but most people don?t make those choices because they never sit down and run the numbers.? Now, I left out a common choice that is more commonly chosen: invest more aggressively.? This is more commonly done because it is ?free.?? In order to get more return, one must take more risk, so take more risk and you will get more return, right?? Right?!
Sadly, no.? Go back to Defined Benefit programs for a moment.? Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.? What have they earned?? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion?s share coming from the less risky investment grade bonds.? The overshoot of the ?90s has been replaced by the undershoot of the 2000s.? Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.
The article goes on, and there are several others that flesh out the ideas further:
This piece is an experiment. ?A few readers have asked me to do explanations of simple things in the markets, and this piece is an attempt to do so. ?Comments are appreciated. ?This comes from a letter from a friend of mine:
I hope I don?t bother you with my questions.? I thought I understood bid/ask but now I?m not sure.
For example FCAU has a spread of 2 cents.? That I understand – 15.48 (bid) ? that?s the offer to buy and 15.50 (ask) ? that?s the offer to sell.
Here?s where I?m confused.? How is it possible that those numbers could more than $1 apart? EGAS 9.95 and 11.13.? I don?t understand.? Is the volume just so low? ?And last price is 10.10 which is neither the ask nor bid price.? Can you please explain?
You have the basic idea of the bid and ask right. ?There is almost always a spread between the bid and the ask. ?There can be occasional exceptions where a special order is placed, such as an “all or none” order, where the other side of the trade would not want to transact the full amount, even though the bid and ask price are the same. ?The prices might match, but the conditions/quantities don’t match.
You ask why bid/ask spreads can be wide. ?I assume that when you say wide, you mean in percentage terms. ?Here the main?reason:?many of the shares are held by investors with a long time horizon, who have little inclination to trade. ?Here is a secondary reason: the value of the investment is more uncertain than many alternative investments. ?I believe these reasons sum up why bid/ask spreads are wide or narrow. ?Let me describe each one.
1) Few shares or bonds are available to trade
Many stocks have a group of dominant investors that own the stock for the longish haul. ?The fewer the shares/bonds that are available to trade, the more uncertainty exists in where the assets should trade, because of the illiquidity.
Because few shares are available to trade, price moves can be violent, because it only takes a small order to move the price. ?Woe betide the person who foolishly places a large market order, looking to buy or sell at the best price possible. ?I did that once on a microcap stock (the stock of a very small company), and ended up doubling the price of the stock as my order was fully filled, only to see the price fall right back to where it was. ?Painful lesson!
As a result, those that make markets, or ?buy and sell stocks tend to be more cautious in setting prices to buy and sell illiquid securities because of the difficulty of trading, and the problem of moving the market away from you with a large order.
I’ve had that problem as well, both with small cap stocks, and institutionally trading illiquid bonds. ?You can’t go in boldly, demanding more liquidity than the market typically offers. ?If you are buying, you will scare the sellers, and the ask will rise. ?If you are selling, you will scare the buyers, and the bid?will fall. ?There is a logical reason for this: why would someone come into a market like a madman trying to fit 10 pounds into a 5-pound bag? ?Perhaps they know something that everyone else does not. ?And thus the market runs away, whether they really do know something or not.
In some ways, my rookie errors with small cap stocks helped me become a very good illiquid bond trader. ?For most bonds, there is no bid or ask. ?Some bonds trade once a week, month, or year… indicative levels are given, maybe, but you navigate in a fog, and so you begin sounding out the likely market to get some concept of where a trade might be done. ?Then negotiation starts… and you can read about more this in my “Education of a Corporate Bond Manager” series… I know most here want to read about stocks, so…
2) Uncertainty of the value of an asset
Imagine a stock that may go into default, or it may not. ?Or, think of a promoted penny stock, because most of them are in danger of default or a dilutive stock offering. ?Someone looking to buy or sell has little to guide them from a fundamental standpoint — it is only a betting game, with volatile prices in the short run. ?Market makers, if any, and buyers and sellers will be cautious, because they have little idea of what may be coming around the corner, whether it is a big news event, or a crazy trader driving the stock price a lot higher or lower.
For ordinary stocks, large enough, with legitimate earnings and somewhat predictable prospects, the size of the bid-ask spread reflects the short-run volatility of price. ?In general, lower volatility stocks have low bid-ask spreads. ?Even with market makers, they set their bid-ask spreads to a level that facilitates trade, but not so tight that if the stock gets moving, they start taking significant losses. ?And, as I experienced as a bond trader, if news hits in the middle of a trade, the trade is dead. ?You will have to negotiate afresh when the news is digested.
As for the “Last Price”
The last price reflects the last trade, and in this era where so much trading occurs off of the exchanges, the bid and ask that you may see may not reflect the true state of the market. ?Even if it does reflect the true state of the market, there are some order types that are flexible with respect to price (discretionary orders) or quantity (reserve orders). ?Trades should not occur outside of the bid-ask spread, but many trades happen without a market order hitting the posted bid or lifting the posted ask.
And though this is supposed to be simple, the simple truth is that much trading is far more complex today than when I started in this business. ?I disguise my trades to avoid alarming buyers or sellers, and most institutional investors do the same, breaking big trades into many small ones, and hiding the true size of what they are doing.
Thus, I encourage all to be careful in trading. ?Until you know how much capacity for trading a given asset has, start small, and adjust.
All for now, until the next time when I do more “simple stuff” at Aleph Blog.
