Laurent Bernut
Jul 22, 2017 · 4 min read

Today my risk is 7.3%. Probability of losing 7.3% is sub 8% (sorry, there is not enough of a data sample to be more accurate). That is my risk today.

Risk is not this uncontrollable imaginary event that may cause a hole in your portfolio. Risk is how deep you will allow that hole to be

Risk is not a story in China

When i used to work with Fundamental market participants, every time they talked about “risk to the investment thesis”, they stepped into dissertation mode. Risk had to do with interest rate, the FED, Chinese consumers, blah blah blah. Then, they had the three scenario routine: Best, worst and probable case, all this served with some imaginary probability. Week after week, the same risks were paired with a different stock, like freedom fries and fish, steak, chicken and pretty much everything else. 4 major flaws in the methodology:

  1. Control: They invoked stuff over which they had no control. Fed or Bank of Japan, really? Looks a bit beyond the control of a senior analyst. Risk has to be brought down to something you can exert control over in your portfolio.
  2. Obvious risks: Sure, if the FED raises rates, something will happen, but then so what? It was a routine exercise with risks that everyone would relate to and feel good about. Risk is not this unforeseeable “force majeure”. Risk leaves a trail of milestones that eventually lead to a crisis. The GFC started in 2006, festered in 2007 and blew up in 2008
  3. Probabilities: did they ever stop and consider how much bias there went into the probabilities? How did they come up with the numbers in the first place? Did they ever seek feedback on their probabilities? Accountability is how weather forecasters get better at what they do
  4. Quantification of risk: risk is not some cute dreamed up probability. Risk has some hard number consequences on your portfolio. Risk is not this uncontrollable imaginary event that may cause a hole in your portfolio. Risk is how deep you will allow that hole to be

All in all, the biggest risk was that their ignorance about risk. It was that bit that put me off fundamental analysis. I was showing up with gain expectancy, density probabilities. They rolled their eyes and asked while yawning out of mathematical boredom: “yeah, yeah, but what’s the story?”

Volatility is not risk

Many academics and some market participants equate volatility with risk. They are different. Volatility is uncertainty. Volatility = risk makes for pretty and overly simplistic equations that academics love. It all works well in academical clean rooms.

Sharpe is not a measure of risk. It is a measure of volatility adjusted returns.

Popular is not a good reason to adopt Sharpe and volatility as proxies for risk. Owing to the Hippocratic theory of humours, doctors bled their patients for centuries until they finally realised it was a stupid idea.

Risk is a number

To me, risk is a number: my total loss if all stop losses are hit. Today, it is 7.3%.

There is no open ended risk. All positions have logical stop losses. Stop losses are used to calculate position sizes. Position size is calculated using risk per trade. RPT varies depending on the equity curve (check out the blogpost on something your brain can trade). Ultimately i have set minimum and maximum risk per trade depending on my tolerance for risk. Whilst minimum is relatively straightforward, maximum risk should be a probability and i can’t find the formula.

My perception of risk, my tolerance, varies according to my profitability. When I am profitable, my inner idiots wants to take more risk. When performance suffers, i want to take less risk and will pass up obvious opportunities.

I do not trust myself. I do not trust my inner idiot to come up with an optimal risk assessment. This is why i set boundaries and trust a formula to operate within those confines. This is something my inner idiot can execute w/o derailing.

I believe this approach to risk is robust:

  1. every position has a closed ended risk budget. See note on stop loss
  2. Risk budget moves within bands. My inner idiot can respect those rules
  3. Overall risk budget is half my tolerance for risk. I can live with that. I will not be happy or rich, but i can live with that.

Note on stop loss

Stop loss is a vastly under-researched topic. You will rarely be filled at stop loss. There will be slippage. That is a position sizing issue. Take a little less risk so as to size a little smaller so as to respect your stop loss budget.

Stop loss is a logical issue. Think about where you place them because having them triggered is an inefficient way to trade. We have wide stop losses so that more often than not Longs are closed and Shorts entered w/o triggering stop losses.

Stop losses are like brakes. You would not get into a car if it did not have brakes, would you? Read the blogpost on the psychology of stop loss

The classic question from fundamental dudes is: “but what happens if […] and price blows through your stop losses”. This can happen, i am aware of that but probability is low and even if it did i would still be in better shape than all the guys who operate w/o stop losses. Overall, I made money when the Brits decided to take a step back on evolution. I made money with the US turned into a banana republic. Some positions worked, some did not and the result happened to be axed in the right direction

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