Measuring Risk

I had the following comment left on a post about Morningstar from the other day.

I use Morningstar only for its raw data especially in mutual funds. The writers at Morningstar tend to offer too much personal(mistaken as professional)opions than the data would suggest. Till this day Morningstar has yet to come up with any good risk measurements for its funds or stocks. I would like you to write how you personally balance the reward with risk for your clients. After reading your blog for a while, I sense you probably know this area better than most people. I would appreciate if you can share some idea with us.

I'll take a stab at this but it may be difficult to articulate. Part of my idea about how to manage money is to look at the big picture first and try to assess what parts of the market are likely to have a shot of outperforming based on history and current events. Buying a Chinese oil stock was less risky two years ago than it was six years ago. Buying mega cap now is riskier than buying it in 1996.

In making decisions about what sectors, countries, style or cap size to overweight or underweight I am trying to reduce risk where possible. If I think tech will lag I would underweight it. An area of the market I expect to lag carries more risk as I see it, for the time being anyway.

When I get to sector composition I look to blend together various type of volatilities to capture whatever effect I think makes sense. For example with energy; I have been overweight for a long time. In the sector I have owned two large, foreign integrated oil companies, a second tier oil company with refining exposure and one of the Chinese oils.

Last fall I added beta with one of the tanker names and also Murphy Oil (MUR). I felt it was a good time to add beta. It turned out to be a good entry point for beta. I managed the tanker name poorly. It shot up a lot but I held on too long and most clients broke even or lost a little. I wrote about getting stopped out on MUR on the blog, but I may not have disclosed the name. Since I sold MUR the stock has languished compared to the rest of the group. In the mean time three of the oils I still own (lower beta, relatively) are up a lot, as you might expect for any energy stock.

The decision to reduce beta was motivated by a gut feeling and what had been a big move up to that point. Generally an area of the market is riskier after it has gone up a lot. This is obvious and simple but true.

One aspect of this topic I have written about before is watching a stock for several months to learn how it reacts to various kinds of news. As an example, last fall I wanted to add a little beta in consumer growth so I bought Advance Auto Parts (AAP). This stock is a hot potato and has been for a while. I bought in around $40 or so and it seemed like once a month it would have a week where it would go up 10%. I finally got stopped out this summer around $65. Since then it has traded around $61. The point is I knew ahead of time it could have big moves, I expected it to add a lot of alpha in a market that was not down. Had the market been down I think it would have lagged badly. Although it went up more than I thought it could, it generally filled the exact role I had hoped for.

On the other side of the risk coin would be a name like Johnson & Johnson. Just about every client owns it. I have mentioned before my view that the market is a great place to get rich slowly. JNJ is exactly the type of name I think about as applying to that phrase.

I don't know if this really answers the question or not. The thing here is that by learning how a stock reacts to news first hand, not just looking at a chart, I think I get a feel for what the stock can do. It would be naive for me to think I will always be correct but this allows to feel more confident about what I own. I also look at text book numbers like beta and so on.