How much have your investments dropped in the past month? If you have lost more than you expected then you probably took more risk than you realised. Sadly most people do not pick stocks by looking at risk, but on return instead.
When was the last time you picked a stock by considering how much you could lose? You probably think mainly about gains.
Information on returns is ubiquitous, so it is excusable not to consider likely losses.
Before a trade I spend about double the time in trying to quantify my potential losses as I do in calculating possible gains.
Online investors seldom know how much risk they are taking. For instance, how are you supposed to know which investment is riskier (i.e. whose returns are more variable) when comparing apparently similar stocks? Now a new tool on riskgrades.com shows exactly how to evaluate these risks.
Other sites quantify with certainty your risk, leaving no excuse for flying blind. So, how about this for a new way to trade: you tell the website how much you want to gain if the FTSE, Dow, or various stocks touch certain levels chosen by you.
It then tells you how high the risk will be.
For example, at betonmarkets.com, if I key in: "I want to win €3,400 if the FTSE closes above 4,400 in two months," the website calculates the amount I must invest. If I win I get €3,400, for which I have to put up a stake of €1,500. Or how about winning €3,000 if the Dow closes above 8,700 in two months. This will cost me €2,000.
But whether either trade is worth making depends on your view of the index. At least you know for certain your risk and reward levels.
You should be able to avoid unexpected losses after improvements by online brokers such as IGIndex.co.uk allow you to set guaranteed maximum losses. So if you fixed the maximum loss at 15 per cent, then even if the stock plunges 25 per cent you will know for certain your maximum cost. That is a degree of certainty that was previously often unavailable.
Covered warrants, to be launched next month, also mean fewer excuses for not quantifying risk. Covered warrants ( www.londonstockexchange.com) work like equity options, providing the right to buy (a "call warrant") or sell stock (a "put warrant") at a pre-determined fixed price.
With their introduction in September will follow an innovative new online tool that allows investors in effect to ask "which specific covered warrant do I buy if I want the greatest return from, say, a 10 per cent rise in Vodafone, what are the chances of that happening, and what's the most I could lose?"
The forthcoming www.optioneasy.com will do the same for stock options. Again both try to quantify your potential losses and maximise your gains for a given level of risk.
Unexpected losses are not the only danger of not quantifying risk. Consider this: you may be unhappy to accept a bet where you win €150 on heads and lose €100 if it comes up tails. (A 50-50 chance of gain). But you would probably be happy with 100 such coin tosses because the chance of ending up with a gain is greater (better than 50-50 you only need 41 heads in 100 to gain).
Now imagine you do not know the risk and reward of each individual coin toss - that is what trading is like. So let us say you throw five consecutive tails (a bear market). You are likely to reason this is a loss-making game, whereas, in fact, it is not in the longer run over 100 coin tosses.
This is what a big difference knowing risks makes. It prevents panicked unwarranted withdrawal from the market. Unexpected losses and panic selling all have one root cause: unquantified risk.
