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It is important to understand risk and how much of it you
are assuming in attempting to achieve your investment objectives. First,
there is elemental risk. This is what you fear when you cannot sleep, or
are completely distracted by a sense of imminent doom. This is palpable
and should not be tolerated. You need to put your finger on the issues and
ameliorate the condition by raising cash, reducing concentration, etc.
Keep in mind, however, there is risk in being under invested or not in
sufficiently high beta stocks if the market does rise. let's talk about
quantifiable risks.
Beta
This refers to how a stock moves vs. the market. If a stock moves more
than the market, it has a high beta. If it moves little vs. the market it
has a low beta. Technology generally has a high beta while Utilities have
low betas. A portfolio of high beta stocks in a down market can create
extreme downward movements, while up-markets can cause tremendous
performance. If a market is demonstrating extreme risk, it is wise to
raise cash, lower the beta of your portfolio, and even consider some
hedging of exposure.
Valuation
This risk essentially deals with fundamental tools for determining fair
value and the extent to which a stock is over or under valued. For
instance, you would look at Price/Earnings, Price/Cash Flow, Price/Sales
and P/E ratio to sustainable growth of earnings. Looking at these ratios
in a vacuum is useless. Therefore, these ratios should be assessed against
comparable ratios for the industry, the range of such ratios for the
company itself, and the range of such ratios for the market as whole.
Technical Risk
This risk relates to various technical indicators, such as de-trending
oscillators, Bollinger Bands, and simple observations of the extent to
which a stock or market is trading above or below trend-lines and moving
averages. If a stock is extended and approaching imminent overhead supply,
it has risk of a pull-back to support. Stocks in long term downtrends
Economic Risk
This is the risk associated with economic timing. Here, an investor
assesses the extent to which the economy is growing or accelerating its
pace of growth or the reverse. The are winners and losers under these
various scenarios. The portfolio of cyclical stocks as the economy
decelerates or faces imminent Fed Reserve rate increases may be hurt.
Extreme Market Risk
This involves valuation, technical conditions, economic issues, as well as
sentiment. A market that is cheap by historical standards and other
alternatives, that is technically oversold, and that is slowing with
prospects of lower interest rates, may be ready to rally, particularly if
investor sentiment is wildly negative.
Time Period and Nature of Risk- Risk is relative. There is short term,
intermediate, and long-term risk. Short term risk may apply to days or
weeks, and represent only a countertrend pullback of 1% to 7%.
Intermediate risk may apply to weeks to months and may involve higher
levels of risk. Finally, long-term risk normally occurs after a stock is
technically broken and could last for years.
Actions
Too much risk can be lowered by raising cash, reallocating to lower betas,
buying less extended stocks, or barbelling your portfolio with a balance
of value stocks and higher betas.
Additionally, reducing high industry concentration back to more normal
weightings can also lower risk.
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