Risk - What is it and How is it Measured?
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The word ‘risk’ seems to be an ambiguous reference within financial markets. We all know it’s there, but how can it be measured? If a stock goes up, has the risk dissipated? If it goes down, has the risk amplified? How can we quantify the risk of any investment, since it can never be something that is truly tangible? This concept is best explained by legendary investor Howard Marks in this interview.
This week, I decided to give an overview of several metrics which could be used as a proxy for measuring risks within individual investments. However, this is by no means a complete list, and be aware that there are many underlying risks that can’t be easily quantified.
Volatility
Mean Return and Volatility for Overstock (OSTK) and Ruffer Investment Co (RICA), Source: The Spark and Bloomberg Data
One measure that can be useful not only for gauging risk but also for sizing positions is volatility. The table above shows two investments currently held in The Spark’s portfolio, Overstock (OSTK) and Ruffer Investment Co (RICA). This table shows the average return over 5,20 and 60 days (or 1-week, 1-month, 3-months), and the average Sigma – i.e. ‘Volatility’ (or 1 Standard Deviation move for you math geeks) – over the three timeframes. For Overstock, the 1 sigma was a whopping 111%, compared with 4.4% for Ruffer. So, what does this mean?
In simple terms, Sigma/Volatility/Standard Deviation all means how much a stock is likely to move. A 4.4% realised 3-month volatility means that Ruffer’s share price is likely to move up or down 4.4% from its average return in any given 3-month period. Why is this useful? When sizing a position, we need to think about the overall effect each individual position will have on a portfolio. Allocating a large portion of capital to Ruffer (as I did in The Spark’s portfolio – 7.5% of capital), will reduce the volatility of the overall portfolio. This would be beneficial if I believe we are entering a period of low growth or recession (I do) because Ruffer has low volatility and is a well-diversified portfolio aiming for capital preservation. On the other hand, contributing a large portion of capital to Overstock will have the opposite effect. This is something I must consider with every position I take, as position sizing and volatility can substantially affect The Spark’s portfolio returns, especially in bear markets.
The Spark Portfolio’s Standard Deviation breakdown
Comparing the standard deviation’s across The Spark’s portfolio, we notice how important it is. Have a look at the 60-day sigma (colour-coded to the right of the above table) of Physical Gold versus Digital Turbine - 15% vs 62% (yellow boxes)! The colour-coding shows that these movements are both within their respective stocks 1-2 sigma moves, but obviously, 62% is a hell of a lot larger than 15%. A 1-2 sigma move is not considered excessive, which conveys the monumental difference in these investments.
Easy Alternative
Rather than spending the time building models that will calculate these moves as I have, one easy alternative is to look at a stock’s Beta (which can be found on Yahoo Finance for free). Beta is a measure of the volatility of a stock compared to the market (the S&P 500 for example). The S&P 500 has a Beta of 1, so any security with a Beta greater than 1 is more volatile, and any with a beta below 1 is less volatile than the market. From this, we can then do a simple calculation to find out the beta of The Spark’s portfolio as a whole using the weighted beta. The weighted beta is simply each individual stock’s beta, multiplied by its percentage weighting (capital allocation) within the overall portfolio. Once again, if the portfolio’s weighted beta is greater than 1, the portfolio of stocks is more volatile than the index, and if it’s less than 1 it has lower volatility. Generally speaking, it is good to have a lower volatility portfolio in times of uncertainty or recession. The Spark portfolio currently has a weighted Beta of 0.8. This can be a good indication of how much risk you are exposed to. I could go into more detail on the trade-off between risk and reward, but that will be a topic covered another time!
Weighted Beta across the Spark’s portfolio - see overall portfolio beta in the top right box
Liquidity is Key
Liquidity is rarely discussed in financial columns, but in my opinion, it is one of the most important topics for retail investors to understand. In layman’s terms, liquidity is how easy it is to buy and sell a stock. A highly liquid stock has a lot of shares in circulation, and many millions of pounds are traded in the stock each day. Examples include Apple Inc and Amazon. On the other hand, less well-known or smaller stocks (small-caps) may have poor liquidity. Generally, this is because large institutions aren’t buying the stock so it can be harder to acquire shares, especially in times of market turmoil. This can be seen below with the S&P 500 during the COVID-19 sell-off (the same is occurring today). The ‘gapping’ down of the market and big candles seen in these charts shows that volatility is high and liquidity is poor because large sellers have entered the market and no one wants to buy, exacerbating the swings in price.
COVID-19 Sell-off, low liquidity amplifies moves, Source: TradingView
Nothing is free
Why is this important for retail investors? The rise of free trading apps. Such apps have been great in getting more people involved in the stock market, however, you must understand how these platforms (such as Trading 212) operate. These platforms are free because they operate on over-the-counter (OTC) settlement systems. This can be explained with a simple example.
Imagine times are tough, and you need to raise some cash. You search your house and find an orange you want to sell to raise this cash. You go to the local food market to sell it, however, upon arriving at the food market you discover no one is there. So, you wait…. And wait… and wait. Eventually, after three weeks, a buyer arrives at the food market. By then, you are desperate to sell for any price, as you have got so hungry you almost ate the orange! The buyer offers a ridiculously low price, and you accept because you are fed up and don’t want to wait any longer.
This is exactly how OTC markets work. If you would like to sell shares in Amazon, there needs to be a buyer on the other side of the trade. If there is no one else on Trading 212’s platform willing to buy, you will be stuck ‘holding the bag’. It could be weeks before you are able to sell it, by which time you have become desperate to sell and someone picks it up at a bargain price. This is what is described as a lobster pot – it’s easy to get your hand (money) into the pot (stock), but not so easy to get your hand out (lobsters tend to snap!). This concept is the reason why I hold a large portion of cash in The Spark’s portfolio at present. Once the capitulation selling begins, I will pick up stocks at bargain prices from those desperate to sell.
Security Specific
With individual stocks, there are many questions you can ask yourself to ensure the risk-reward is skewed in your favour. See this article for a more detailed version. One example is the debt structure of the business. How much debt does the company have, and can this be covered by its cash and short-term assets? Overstock is a good example of this. It is highly volatile due to its business cyclicality (furniture selling) and crypto investments, but it has $450m in cash and no debt. It also holds no inventory, as the company ships furniture directly to its customers. There is absolutely no way this company can go bankrupt, so I am happy to commit a higher allocation of capital to the company and sit through the volatility, hoping to be compensated for it later. Other company-specific risks include: the management’s ability; the company’s cash burn on investments; the strength of its margins; and dilution through share/debt issuance.
More generally, different securities have different risk factors. Bonds are riskier in times of high inflation and Gold is dangerous to hold in times of rising real rates for example. For a better understanding of the interplay between asset classes and market cycles, I highly recommend you read ‘The Long Good Buy’.
Currency Risk
The US Dollar has appreciated substantially this year against all major currencies. It has risen over 14% against the British Pound. This has been good for UK investors who have invested in US stocks, as this means their investments have appreciated by 14%. However, this can quickly turn from a tailwind to a headwind if the US Dollar begins to fall. Find more about currencies in this article. Currency risk is something that many retail investors do not think about, but it can be a substantial influence on returns.
Geopolitical
Given the current war in Ukraine and tensions between China and the US, I don’t think this risk needs an introduction. Geopolitics is extremely difficult to protect your investments from. My personal rule is that if there are significant rises in geopolitical tensions, it is better to get out and look elsewhere for investment opportunities. One example was my investment earlier this year in Polymetal International (LSE: POLY), a Russian Gold Miner. I had invested in the company at the end of 2021 as I was bullish on precious metals, however as soon as I discovered that UK Diplomats were being pulled from Ukraine, I sold the position. Since then, the stock has fallen 95%. Overall, my two cents is to exit the position.
Ouch! Geopolitical risk can cost you - Polymetal International (POLY) Share price, Source: TradingView
On a (more bleak) final note, I would like to briefly mention that this bear market is very different from others investors have faced over the last 20 years. Since the 2000 dot-com bubble crash, central banks have been able to cut interest rates and print money in order to stimulate the economy and support the stock market as recessions have come. We have witnessed ‘V-shaped’ market recoveries due to this monetary support i.e. sharp falls followed by sharp rebounds to new all-time highs. This time central banks will struggle to do so because of the high inflation we are experiencing. They need to kill inflation to maintain credibility.
Looking at history tells the best tale. The 1929 crash led to an 86% fall in the S&P Composite index (S&P 500 back in the day). It was not until 1954 that the index exceeded this 1929 high. Don’t expect the V-shaped recovery again this time, because recent bear market recoveries have been anomalies rather than normalities.
Know what you own
All of the topics mentioned above really come back to one core principle key for investing success - knowing what you own. Understanding the risks associated with investing is a never-ending process, and although I am far from an expert, I hope this helped you understand the main risks I believe face investors today.
Portfolio Return Year-to-date: -0.7% vs S&P500: -15%
Total Return since inception (20/09/2021): 5.2% vs S&P500: -6.6%
Let me know your thoughts by emailing me at thesparknewsletter@gmail.com
See you next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.