How To Use Risk As Currency

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Investing is the trading of risk. Money managers use this risk as a currency to buy profit. Their goal is to generate the highest returns per unit of uncertainty, creating a repeatable process for continued success.

Consider the gambler going all-in on a roll of the dice for a big win. Regardless of success, the process has a very low probability of creating a repeat performance. In contrast, an investment strategy that uses risk to buy profit is much more constant.

Risk has a Memory

In finance, risk is the measure of past volatility. The amount of fluctuation present in price movements. "Different kinds of price series exhibit different degrees of memory," explains Benoit Mandelbrot, the French Mathematician who studied over 100 years of market prices.

A random walk does not represent a risk. Instead, the risk is influenced by and remembers past events. "What a company does today-a merger, spinoff, a critical product launch-shapes what the company will look like a decade hence," reveals Mandelbrot.

The Black Box

Mandelbrot discovered that prices do not follow a bell curve. Instead, they model a power law. "It leaves room for many more big price swings than would the bell curve," he concludes. "In financial markets, God can appear, anyway, to play with the dice."

The risk in financial markets is more in line with Quantum Theory than basic probability. "Finance is a black box covered by a veil," states Benoit. We can only see inputs and outputs, never able to witness the inner workings.

In his book Black Swan, Nassim Nicholas Taleb declares, "what you don't know is far more relevant than what you do know." Markets move based upon anticipation, not facts. It is the beliefs and fears of millions of people that influence markets. "Everyone thinks he knows what is going in a world that is more complicated (or random) than they realize," explains Taleb.

States of Risk

Before Mandelbrot studied markets, he created fractal geometry. This work cumulated into Benoit's "theory of roughness." An attempt to quantify the jagged and often chaotic reality of natural landscapes. "The fluctuation between one value to the next is limitless and frightening," he describes.

From this work, Mandelbrot concluded three states of randomness: mild, slow, and wild. Like phases of matter, each has specific properties. Mild randomness is like a solid-state with a stable, expected composition. Slow randomness is comparable to the liquid phase, and wild randomness is like the gaseous state—having no foreseen arrangement.

Richard Dennis made hundreds of millions following commodities trends. "I've learned that markets, which are often just mad crowds, are often irrational," Dennis argues. While ultimately successful at predicting many market outcomes, he has also lost $2 million in a single day. The point is that risk and reward vary without warning.

Experience and Hindsight

"How can we know the future given knowledge of the past," declares Nassim Taleb. A turkey lives for an average of 100 days before slaughter. During the first 99 days, it develops expectations on what the next day will bring. However, the events that transpire on the 100th day come as a shock.

The last thing a turkey learns is, "the same hand that feeds you can be the one that wrings your neck." The 1987 stock market crash came as a complete surprise. Taleb states, "there was no antecedent." For years after, many traders anticipated another one each October.

According to Richard Dennis, big money in trading occurs when one can go long after a significant downtrend. Instead of relying on the previous series of events to continue, he banks on change. While not always correct, Dennis is right enough of the time.

Trends and Volatility

Hedge fund veteran Andreas Clenow states, "volatility is required to make returns." What he seeks is to pay for performance using as little uncertainty as possible. "Returns always have to be put in the context of volatility," declares Clenow.

Both risk and return have a time component. Richard Dennis knows when a trend is occurring. The problem is that he does not know when it will begin or end. He could enter a trade at the bottom of a downtrend only to discover that it has further to drop.

Therefore Dennis must use this risk to purchase the significant return he desires. The question is, how much risk does it cost.

The Cost of Uncertainty

Trading uncertainty is like ordering at a lavish restaurant. Everything on the menu sounds magnificent. Yet, the prices are not listed. You have to eat the meal before knowing the actual cost.

If you have eaten at the restaurant before, you may have a reasonable estimation of how much the dinner will be. However, they may have raised or lowered the cost since the last time you were there.

Conclusion

The most successful investors rely on reproducible returns per unit of risk. However, the movements of the past do not reveal future volatility. It may be slight or massive because markets move based upon the anticipation of millions of participants, not facts.

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© 2020 Todd Moses

The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.