There is a rumor going around that "risk management" means buying
and selling options in the stock market. This is nonsense. Stocks in the
market are a positive value representing shares in the company. When you
own 1% of the shares of that company, you own 1% of its assets: its bank
accounts, buildings, machinery, goodwill, accounts receivable, less debts
and payables. If the company closes its doors, you get that 1% of the sell-off
price. Risk is not a positive value like stock or food or energy, which
can be bought and sold because it has intrinsic worth when it is finally
consumed. Nobody wants to buy risk. It's more like garbage, which
somebody will take off your hands if you pay them more than it costs them
to pass it on to on the next party, or dump on a landfill somewhere.
Everything in life has risk associated with it. Risk is a fact of life, and almost all of us learn to manage risk in acceptable ways. We buy insurance, and we avoid (or perhaps seek) particularly risky activities. Buying stock is risky, more so than putting your money in the bank. Putting money in the bank is risky too, just not very much. It is protected there by FDIC insurance, but if the government goes bankrupt (a very real possibility after the 2008 election) you could still lose. Inflation might devalue your bank deposit faster than interest increases it. Those are risks. You manage financial risk like this by diversifying, putting some of your assets in the bank, some in real estate, some in the market, or else you manage the risk by ignoring it and accepting the loss if it comes. There is a risk that some asteroid might hit the earth and destroy all life. That's not very likely, and we can't do anything to prevent or escape it, so we manage that risk by ignoring it.
Insurance is another form of risk management. There is a risk that you will mash your car into another. It happens seldom enough to any particular person that many people tried to manage that risk by ignoring it. Unfortunately, that impacts people other than the driver at fault, so driving carefully is not always a reasonable defense. Most states now have laws requiring some form of insurance. How does that work?
Let's suppose, for a simplified example, that on average one car in 20 gets involved in a fender-bender which costs (again on average) $1000 to repair. One car in every 200 is totalled, which the insurance company pays out low blue, $20,000. So an insurance company might write 1000 policies to aggregate those risks, reasonably expecting to pay out five claims of $20,000 and fifty claims of $1000 in the average year. That's $150,000 in claims. They also need to pay two adjusters and two salespersons at $50,000 salary (including benefits), plus the president at $100,000 annual salary, plus office expense (rent, utilities, janitor service, office parties, etc) at $40,000, and have something left over for profits (dividends) to the stockholders, perhaps 10 cents per share for 100,000 shares. So they price their policies at $500/year (on the average). There are specialists in calculating these averages, with particulars for age and gender and model of car, and so on. Oh wait, gender is no longer a lawful distinction; it still makes a difference, but the insurance companies must pretend otherwise. It doesn't matter to the companies, they make their profit anyway; it's the safe drivers who are screwed. If you look at these numbers -- actual insurance figures will be comparable -- you can see that $150 of each driver's premium is going to pay out claims, and the other $350 goes to insurance company profits and (mostly) operating expenses. That's not a particularly good deal, but it's risk management, a steady $50* a month instead of $1000 or $20,000 all at once in those 6% of the cases where it's necessary. Insurance is like that. You pay the insurance company $38/month, over and above the statistical cost of the accidents, to take (most of) the risk off your hands. I pay the local garbage company $15/month to carry off empty cans and wrappers and bones.
The people telling me about "risk management" in the stock market seem to be bound by some kind of non-disclosure agreement (NDA) preventing them from saying exactly what they mean. One wise person put it this way: "Men love darkness rather than light because their deeds are evil." You hide what you are doing when you are ashamed of it. It's hard to refute specifically what we don't know the specifics of. Nevertheless, we can make some reasonable inferences.
The first and most important thing to understand about the stock market is that all the money going into the market comes from investors buying stocks or other stuff (called "derivatives") like options, and all the money coming out of the stock market and making the investors rich went in somewhere else. The market does not "create wealth," it only moves money around. Except for the brokerage fees (and dividends, which do not go through the market at all), the stock market is a zero-sum game. Every dollar an investor takes out of the market in profit, some other investor put in (and did not get back out) as loss. It only works because some people's idea of a profitable investment is different from somebody else's idea: you need both buyers who think this stock is worth more than the listed price and sellers who think it's worth less; otherwise there are no trades and no profits (and losses). Trading in options and other derivatives may obscure or obfuscate that fundamental fact, but it does not change it.
Second, the stock market is risky. There is risk in doing business, and much of that risk is assumed by the stockholders. If the business folds, they lose their investment. The investors know that going in. Nobody is looking to offload their risk at a 200% penalty, and nobody wants to buy risk to resell at a profit. Risk has no positive value. Nobody is actually buying and selling risk, and if they tell you that's what their formula does, watch your behindside. The function of derivatives is to obfuscate the nature of the risk so people will be tempted to buy at a higher price than the risk justifies. This happened in the mortgage market with what was called the "copula formula" and the result was a disaster that devastated the housing market. People did not understand the risks.
Third, there is no actual connection between stock price and the intrinsic net present value (NPV) of the company assets. NPV is an accounting term reflecting the cost of money and the associated risks of future profits or losses. The wise investor will calculate the NPV on a company and pay no more (nor sell for less) than the NPV as calculated. If there were a hard connection between stock price and NPV, then everybody's buying and selling criteria would be identical, and there would be no significant capital gains. But stocks move all the time. Day traders buy and sell many times in one day. Some of them get rich, more of them lose money. They are guessing, not what the company's actual worth is from minute to minute (because it doesn't change that fast), but what people will think it's worth from minute to minute and day to day. There may be an indirect link to NPV (because there still are wise investors), but it's only in the mind of the investors (if at all).
Therefore, ultimately, if you are going to make significant profits in the stock market, it will be because you made better guesses than the losers. If you think you have a formula, and if that formula works, then the losers will notice that you are winning and they are losing, and they will abandon their losing formula for something more closely resembling your winning formula, after which they will not be losing to you -- which means your formula stops working. That's a necessary consequence of the fact that this is a zero-sum game. Just using the formula changes the market.
As for the people selling their formula? Maybe they know better, and are trying to convince you to buy their formula because they are actually using a different formula that benefits from your ignorance. Their hidden formula works so long as there are bozos using the formula they are selling, and they get you coming and going. Or maybe they are themselves bamboozled, the blind leading the blind. In another essay I discuss the nature of wealth, and how business success is tied to population growth. The Devil, who is the Father of all lies, has been pushing the population limits agenda successfully, so that all major industrial nations now have negative growth (USA immigration slightly overcomes the net loss); it would fit a demonic agenda to deceive gullible investors into thinking that the market can only increase, while his faithful followers sell short just before the crash. Good risk management calls for not getting suckered into that game.
Tom Pittman
2010 December 13
* $500 divided into 12 monthly payments is actually closer to $42/month, but the extra processing and the cost of the money gets charged extra.