Lesson 3 – Risk: What is it?
"If you understand and accept risk, you will never risk too much again"
Risk Management: Making Your Trades Profitable
Traders are constantly trying to develop better strategies that will help them predict where the market will go with more accuracy. Risk, a lot of people think, is when the future doesn’t do what we tell it to. We expect the market to go up, but risk the market going down.
However, risk is actually much more complicated than that, and a lot more important to investment. In fact, risk is the very reason that stock markets and trading exist in the first place. Trade and investment certainly existed before Mercantilism, but it was during the 15th century when equities trading, as we know it today, began to develop.
The major factor in developing trading houses–originally investors who would get together in coffee shops in Venice, Genoa, London and Amsterdam—was helping investors cope with risk. Back then, major trading involved spices from the Orient and futures on crops.
Mills established the first form of “futures” by trying to guarantee grain supplies when farm output depended on varying weather conditions. Millers would agree to buy grain from farmers at a predetermined price early in the season, so that if there were early rains and grain crops spoiled (causing a spike in the price of grain due to scarcity), they could still afford to buy it. Farmers would sell their “future” grain to guarantee that they would still get a profit if the weather was especially good and prices fell due to extra production. Therefore, futures were created to help businesses cope with risk.
The stocks and shares we trade today come from shipping. Although bringing spices, silk and other commodities from the Orient was very profitable, ships had a nasty habit of being taken by pirates or sunk in storms. Sometimes shipments were delayed. If an investor put all of his money into one shipment, he could make a lot of money; but if something happened to the shipment, he’d be completely ruined (the apocryphal “pound of flesh” being exacted in payment).
To combat this, traders would form “companies” that would spread out the risk of losing cargo, so that if one ship sank, it wouldn’t ruin the business. Investors would have “shares” in the venture; and eventually began to buy and sell the shares.
Hundreds of years later, we have advanced financial systems and institutions; but the basics remain the same: Wall Street, the City… they are all based on instruments designed to reduce or manage risk. Failure to manage risk leads to bankruptcies, stock crashes and even world recessions.
Therefore, it’s important for every trader to understand that risk is an inextricable and essential part of trading within the markets. Risk can never be eliminated: therefore it must be managed.
In popular media, traders are often dismissed as “gamblers” who play with other people’s money. That is not entirely true. It’s an accepted truism that says, “the house always wins.” What’s the difference between the house and the gambler? The house practices risk management, and the gambler does not.
Do you want to be the house or the gambler?
Risk is Profit
And why does someone start a business? To make money, of course! As well as help out in the community, create jobs, etc. Starting a business, of course, is very risky; and the idea of the entrepreneur is to make more money than he’s putting in.
Now, lots of entrepreneurs don’t have enough money to start their own business, and often have to borrow money from the bank. But that’s okay; the business will make enough money to pay off the loan, and still leave the owner with a profit.
Of course, the interest rate that the entrepreneur will pay for the loan from the bank will be higher than the interest the bank is paying them for depositing their money there. The bank is calmly pocketing the difference for doing nothing more than having an office with a sign that says “bank” above the door.
So why should someone with extra cash not just loan the money directly to the entrepreneur? If they have extra cash, and the entrepreneur needs money to start a business, surely they could make a much better profit than the interest they receive by putting their money in the bank?
The obvious issue is that the money is safer in the bank. If it is given to the entrepreneur, there is the risk that the business might not be as profitable as expected. It might even go bankrupt, and in that situation, what guarantee does the loaner have that the loanee won’t just run off with his money?
Most people are willing to make less money by depositing money in the bank because it’s safer than giving it to someone to start a business. Besides, you can take your money out of the bank whenever you want; but not from a growing business.
There is a direct relation between risk and profit: the more risky something is, the more profitable it has to be to attract investors.
But what does this have to do with Forex? The same principle applies: the more money you want to make, the more risk you have to take. The more risk you have to deal with, the more important it is to manage that risk.
The bank in this example makes money solely by risk management. It collects deposits from lots of people, then loans out the money to lots of entrepreneurs at a higher interest rate. By distributing individual risk through the system, the bank manages the risk involved with giving out loans and provides security to depositors.
As an investor in the markets, you want to move from being the person who deposits money in the bank to avoid risk, to being the bank, where you manage risk by investing in different currencies or equities and obtain a higher rate of return.
The better you are at risk management, the more risk you can take, and the more profit you can make.
The simplest form of risk management is to follow conventional wisdom and not put all your eggs in the same basket. Or, as the suits say, “diversify your portfolio”. Of course, there is a little more technique to it than that (and nowadays we just keep all our eggs in the refrigerator anyway).
Diversity in your portfolio is not about buying different currencies or equities, but evaluating the relative risk of your options and distributing your investments in such a way that you have an acceptable risk-to-profit ratio.
Generally speaking, however, by making several smaller investments, you have less risk than if you make one big investment. This is the principle behind banking. Banks run the risk of their clients not paying them back each time they loan out money. By loaning to lots of people, the risk is spread out over all their clients, and it’s easier to compensate for.
For example, say you have an investment opportunity; it really doesn’t matter what it is. For every dollar you put in, you could get back $10; and you can invest in it as many times as you want. But, of course, there’s always risk, and there’s a fifty-fifty chance it won’t work out (which isn’t all that far-fetched; 50% of start-ups go bankrupt in the first year).
So, if you put all your money into it, you could become instantly rich. But, if things go sour, you could lose every penny you’ve got. So, is it worth it? That was a trick question; that’s something a gambler would consider. Traders should be applying risk management instead.
The key here is that you can invest as many times as you want (just like with equities markets). If you make one investment, you have 1 chance in 2 of losing (a 50% risk); but if you win, you get 10 times back. This is expressed as profit:risk. In this case you have profit 10 : risk 2, or 5:1 risk-to-profit ratio.
If you split your money in half, and buy twice, statistically speaking, one investment will lose everything and the other will pay off. So if you invest $100 ($50 in each), in one you will lose $50, but in the other you will make $500. Net profit? $400. If you had invested all of your money, you could have made $900; but you also could have lost everything.
The important thing to remember here is that by splitting up the investment, you are no longer in an all-or-nothing position (gambling) but in a position where it’s much more likely that you will make at least some profit (investing).
Of course, you can reduce some of the risk by using different techniques to try and figure out what will happen, but you can never be certain of the future. Once you’ve minimized as much risk as you can by researching the investment, you can then reduce the investment’s risk by handling how you expose yourself to it.
There are a lot of nuances to improving your profitability by diversifying your portfolio, and these will be covered in more detail in later lessons.