I’ve quantified the types of risk previously. http://www.thestreet.com/story/10507493/1/emphasize-bad-risk-when-investing.html
To him who has ears, let him hear.
Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative. Thus, risk isn’t bad. The objective is to manage risk. Ideally, you would avoid the bad risk and surround yourself with the good.
I’m no expert at this myself, but it’s at least a frame of reference. Understanding the cognitive biases of yourself and others will enable you to exploit weaknesses and command strengths. I’ll start with a real life example. If a desire is to be employed, the two outcomes to either stay at home all day or to go out and look for a job, one would entail more risk than the other, but the good kind. That is, of course, if you actually go and look for a job. Your trip could be the bad kind of risk if you find yourself lost in a local pub around closing time as it is my belief that nothing good happens around then.
So, I want to talk about risk in investing and this likely doesn’t surprise you. I want to describe how the market creates huge inefficiencies and how the awareness of how these come to be can make you a lot of money, and I for that matter. Confirmation Biases enable people to determine causality in situations of total unrelatedness. Fear is an emotional response to a perceived threat. For the most part, when people decide to buy a stock, they don’t consider the possibility of being able to purchase more at a lower price. They are much too optimistic and figure that they are likely buying at what a year from now will be the 52-week low. When the stock price starts to go down, it is only natural to question your investment hypothesis, as the perceived threat of losing investment capital increases. What’s ironic about this, is that it’s backwards from actuality. It is my belief that the best investors in the world increasingly question why they want to own something as the price appreciates, that is to say as it becomes more valuable.
Lower prices for the same thing is indeed less risky (the bad kind of risk). I would say that this is surprisingly against what is considered common sense, but as mentioned earlier, confirmation biases enable people to determine causality in situations of total unrelatedness. Systematically, you can create mathematically sound proofs with incorrect underlying assumptions and, well, I’m a firm believer that you can get people to believe pretty much anything — especially when they want to believe it themselves. I’ve found that simply by asking the ‘forbidden questions,’ or the questions that may coincidently discredit institutional wisdom — you may accidently develop a perspective to how things actually work and not how everyone would prefer them to work.
Money is usually made by selling things for more than you paid for them. Some would argue that that is the objective, but I’ll settle for simply not losing money, with the added objective of exposure to good risk, as much as I can get of it. All things considered, prices are the lowest when the fear of loss due to ownership is the greatest. The idea being to sell before someone else sells and the next available price is lower. Naturally lower prices encourage even lower prices given the overwhelming psychological factors that signal fear, which begets more selling. The good news is that if the underlying fundamentals are in tact, eventually the people who live by this creed will run out of shares to sell, and then they will run out of shares to short. As long as the fundamentls are sound, buyers will eventually step in and take it from the sellers at lower prices. That’s the system. How do you beat it when everyone else is predisposed to losing large amounts of money? Well, you plan accordingly. Markets don’t beat most people; they beat themselves. You establish axioms that will enable you to take full advantage of how things work.
- Prices can always go lower, so be ready. Lower prices usually precede bad news.
- As the price of comparable opportunities decrease, so does the opportunity cost of holding what you hold.
- You may have held the most undervalued opportunity in the world, but as the prices of other things decreases, those opportunities may become the most undervalued opportunities in the world. Sometimes selling at a loss is part of a long term profitable strategy.
- Don’t be afraid of a big move to the upside.