It was a Saturday afternoon. It was hot but still early, and I was enjoying the company of good friends and family over tacos and drinks in Inman park in Atlanta.
Talk came to work and a good friend asked me what stocks I own.
Now I know she had some interest but was mostly being polite, so best to give a short and sweet answer then move on. I explained that I liked Western Digital now but mostly went though the disclaimer that I usually cycle in and out of different names to seek a higher rate of return.
Her next question: “You don’t day-trade do you?”
Given her tone, any answer other than “No, of course I don’t day trade” was the wrong answer.
In attempting to answer her accurately but still keep it short and sweet I realized I had found myself in a difficult spot. That exchange got me thinking about how to lay out how I take risk. The following isn’t everything, but there’s enough detail for the casual reader to wrap their head around some basic risk/reward concepts from my viewpoint.
- At the core of what I do and how I think is risk, or in terms of risk. I try to make the most money in the financial markets by risking the least amount of money I can. This should make sense. I’d rather make $100 than $65, and much rather lose $20 than $200.
- At the same time it’s not about taking long shots. Some people think, “Well if I this penny stock goes to just $5 then I’ll make a fortune! Therefore it’s a smart bet“.The further you extrapolate that notion the closer you are to buying a lottery ticket. The difference is entertainment versus investing.
- Here’s and example that may seem strange at first. Sometimes I would rather risk $1,000 to make $500, than risk $500 to make $1,000 if my probability of success varies enough between the two propositions. If my odds of success in risking the $500 to make $1000 are 40%, then over time I will net an average of $100 in that situation.
If my odds of success in risking the $1000 to make $500 are 75%, then over time I will net an average of $125 in that situation.
Risk Win Need to be Right to Breakeven $1,000 $500 66.67% ResultA (lose) ResultB (win) -$1,000 $500 p(a) p(b) EV 25% 75% $125 Risk Win Need to be Right to Breakeven $500 $1,000 33.33% ResultA ResultB -$500 $1,000 p(a) p(b) EV 60% 40% $100
- With some understanding of how to think about risk and reward it’s time for the market is like an ocean simile. Often times the comparison is made between the market and the ocean and it’s a good one. In this comparison individual stocks like WDC are boats and the general market is the ocean.
There are high tides, low tides, violent storms, and days where the water is almost still. The strongest stocks can get smashed on the rocks during violent market declines. Rising tides lift all boats. Conversely when the waters are turbulent some boats may fare much better than others. It’s important to have a feel for the weather and just how far from shore you are before putting any more money at risk. The weather is always subject to change.
- With that said Western Digital was one of those boats that was looking sturdier and sturdier as time passed. Assuming it makes sense within the big picture to buy that stock, how then to go about it?
- Here’s what I was seeing
- From there I choose how much of my capital to risk which is where day trading comes into the conversation.
- In this example I’m betting WDC is going to have a sustained up move over the next couple of weeks. That is not a day trade and I risked 1.5% of my capital. However while I watch the stock market during the day I may see a spot a sudden drop in WDC which I believe to be a very short term opportunity. This leads us into a separate bet based on the larger thesis that WDC is strong.
- Assuming this “drop in WDC” scenario happens, I may enter into a day trade where I risk only 1/10 of a percent of my capital. I would buy the stock during the day at prices I liked, and either lose my 1/10th percent or come out ahead.
- To compare the levels of risk in the big picture trade vs the day trade:
Big picture bet = 150 basis points or 1.5%
Day trade bet = 10 basis points or 0.1%
I am risking 15 times less in the day trade.
- The takeaway is that day trades don’t account for a large portion of risk, and only supplement my returns while I actively manage the stocks in my portfolio. All in all the revenue from my day trades are less than 20% of my gross income. They could be much more but that’s how I choose to risk my capital.
- I risk far less on day trades for a reason. A a prosecutor builds a case against the defense with evidence, and I build a case on my idea before taking on risk.
The heavier the evidence the more risk I might take on and there usually just isn’t that much evidence to justify taking on large risks on a day trade.
- An investor with all the smarts and foresight in the world can still find themselves broke if they stick their neck out too far too fast. Growing an account always boils down to managing risk well.