Risk vs Reward has to be the single most important metric when it comes to investing.

If you only look at one side of the equation you will not getting the full picture.

Let’s first look at Returns. Who cares if you made 50% on your money in a single day, (say on some FDA approval,) if you had an equal chance of losing 50%? That’s called gambling. You could have just as easily gone to Vegas and bet on black. (In Vegas, at least you would get free drinks!)

The same goes with the Risk. You could take ZERO investment risk. Would that make you the best Risk Manager around? Money in the mattress, extremely short duration USTs, there are many places where if focused solely on the risks involved, you could achieve 100% success.

You obviously have to look at both things – together – as a whole. How much Risk am i taking for every level of Return?

The focus of this post will be on how to measure risk.

“Heat”

Yesterday, I had a twitter conversation with my good friend @Legacy_Trades about this very subject, and he followed up with this short article.
(Although I was somewhat offended by his donkey comment, (I think that was more than offset by adding Loeb in the sentence,) the article is – as always – concise & well written.)

To summarize, @Legacy_Trades firmly (to put it lightly) believes that Risk is defined by the amount of money (or %) you are actually down at any given time during the trade. In his tweets he calls it “Heat”. For example,  if you invest in ABC @ $10, and it hits a low of $9.50 and you end up selling at $13 – your Reward was $3 with $.50 of Risk or Heat. Said another way – 6:1 Reward vs Risk.

You can (for the most part (I’ll refer back to this later)) define your risk when you enter a trade by placing stop orders. Say you enter a trade with a target of 50% upside, you not only want to make sure that the Risk isn’t anywhere close to that upside percentage, you also place a stop loss order, so you would exit at that Risk level, and avoid taking more “heat”.

My disagreement with @Legacy_Trades is not that I think this is an inaccurate definition of Risk. It is accurate, extremely useful, and to me shows your “realized” Risk vs Reward.

My main point however is that there are other ways to define Risk as well.

“Volatility”

Without getting into to many quantitative details… A key ratio in judging returns (especially for Hedge Funds, because they supposedly try to hedge and minimize volatility) is called the Sharpe Ratio. The Sharpe Ratio is calculated by taking the Alpha – the Portfolio’s “extra” return over its Benchmark – and dividing it by the Standard Deviation of those returns. The higher the Ratio the better. Other similarly focused Ratios include Jensen’s Alpha & Treynor Ratio.

All of these Ratios have a Risk component and the purpose of the Ratio is to measure performance vs risk – REWARD vs RISK. But in these Ratios, risk is not measured in terms of  a Stop Loss, or Heat taken on the portfolio. (There are measures for that as well – drawdown or maximum drawdown are perfect examples.) Risk, in these cases are measured by the Volatility of the portfolio.

As I’ll talk about later, this measure of Risk is a lot more important when referring to an entire Portfolio’s Risks, but it is also an important measure for individual investments.

“Permanent Loss”

A third and in my opinion the most crucial way to define risk for long term investors, is Permanent Loss. This is especially true if you investing your own money and/or have investors that understand your strategy, and are willing to stomach volatility and/or heat. (I am not naive, there aren’t many of such investors, and if you know any, please have them contact me …)

Think about making an investment in a 10 year US Treasury Bond. (For this illustration, think about a “normal” fixed income era (not the last few years…)) As part of a complete portfolio, you purchase this bond because of its low correlation to rest of the portfolio. You also want the income (interest payments), and therefore plan on holding the Bond until it matures in 10 years.

In this case, is Volatility or Heat important? No. Who cares if the Bond (which say you purchased at Par) trades down to .80 or .90, or if it has swings of 5% back & forth during some volatile period? Your fundamental thesis was to purchase this bond, earn the X percentage (yield), hold it to maturity, and receive your principal back. The only Risks that were taken, was the tiny fraction of 1% chance that the US Govt would default, or (more likely) that you might get paid back with devalued dollars (inflation risk). If you plan on trading this Bond however, its Volatility, and the Heat are very important.

Also, say your return on this Bond is 4% annually, is it really a bad investment if during the 10 year holding there was Heat of say 15%? Would someone say that you took more risks than rewards received?

Imagine on the other hand, your 50%-50% FDA decision “investment” – the pure gamble - let’s say it never took any heat. Say you buy ABC pharma at $10, it never goes below your purchase price and then – boom –  you get the FDA approval and the stock is at $15. Would you say you had zero risk? lol! You might have had zero realized risk, but you had 50% of losing 1/2 your money!

And, guess what? You might have placed a Stop Loss Order at $9.95, for a “defined” risk of .05 vs the potential reward of $5… a great R:R, right? Whoops! FDA day comes, stock gets halted and opens at $5.

This is all about your approach & perspective.

Seth Klarman’s famous “Margin of Safety” clearly isn’t referring to Heat or Volatility.

The conversation started with $YHOO. To me, the Risk in $YHOO at the $14-$16 that it was trading at over the last year leading up to October, was very close to risk-less when you’re talking about an equity (especially in Tech/Media). Not because it didn’t fall much after I purchased it, (which it didn’t,) but because based on my fundamental research and understanding of the company, i felt there was very little chance of a Permanent Loss. I also felt that there was a pretty easily attainable upside – as I’ve written previously in this blog in the past that i thought we can get into the low 20′s.  That is my Risk vs Reward.

Imagine, prior to going up to $19, $YHOO fell back to its August 2011 lows (- the Loeb lows -)… Heat would be -~$5 and now at $19 we’re +~5, so from a heat perspective it would be horrible ~1:1 Risk-Reward. But from my perspective, an $11 stock price, would have been a gift, to where I could load up more – in the same “risk-less” idea. (In a Heat world, you would probably have been stopped out at a loss at ~$13.) One is trading, one is longer term investing.

Same goes with Volatility. i didn’t mind the many swings back and forth between $14 and $16, to the contrary, the stock had extremely low correlation during the year to the overall market – lowering my entire portfolio’s beta. On an isolated basis however, there were many 10-20% swings that if focusing purely on volatility, might have shaken you out.

Was there really zero Risk? No, of course not, there are risks with any investment, and in the case of $YHOO, the risk was my thesis. Maybe I was wrong. But the thesis’ Risk-Reward was great. This is why it’s so crucial to know the thesis behind an investment, and to watch the investment closely, looking for telltales saying your thesis is wrong etc. The thesis in this case though, told me that at the $14-$16 range there was little to no risk for a permanent loss with a clear path to 50% upside. That in my humble opinion is a nice Risk vs Reward proposition.

$ZNGA, similar to $YHOO has little Risk of Permanent Loss in my opinion. Cash burn could get worse, and then the thesis would have to be reevaluated, but at these levels the company is trading near cash + HQ value. The upside isn’t nearly as “base case” as $YHOO’s was, but the potential upside is much higher.

Conclusion:

When managing money for clients, it seems like everybody’s main focus is always on the Reward side of the equation. It is crucial however, to know what Risks are taken in order to achieve the Rewards. ALL RISKS.

On any given trade, you must know what your downside is, if you’re more short term oriented, more trader than investor – put stops, buy puts, enter a trade with a defined number that your willing to risk, and make sure you Reward target outnumbers that Risk level by a huge margin. If you’re a longer term investor, and don’t mind taking heat, (as long as there’s no Risk of Permanent Losses,) know what are the Risks to your thesis. Know how/what/why you might be wrong, and if those Risks appear to be gaining steam know your exit points as well. Volatility too, (even on an isolated investment,) know how volatile this investment has been and how its volatility compares to other holding in a given portfolio. In all cases, you can look at the “realized” risk by seeing the max drawdown (heat taken) on the investment.

From the perspective of a portfolio manager, Volatility of the entire portfolio becomes even more important. Overall, and especially compared to the portfolio’s Benchmark. It is also crucial to know the portfolio’s maximum drawdown.

I have learned so much from @Legacy_Trades over the last year or two. He posts real live trades, he posts size, entries, scale in prices, stop loss prices (& changes), price target objectives, scale out prices, and exits. Everything. He truly is one of a kind on Twitter and adds great value to my stream.

However, it is not the only “right” way. I have found & follow many value-add twitter people (I hope you find me in this camp as well) that posts ideas, thoughts, & themes that do not post buys, sells, or stops. To me the value here is more about theories, theses, & discussions.

Is one better than the other? Sure. I’m sure some people would find more value in actual trades, and I’m sure others would find value in ideas. I do not think one has to post a certain style to add value to a stream. I also do not think they are mutually exclusive.

And yes, when I was sharing my $YHOO thoughts at $14-$16, and begin to see it play out as I expected, (which btw, I do not subscribe to the camp that gives credit to Ms. Meyer for $YHOO recent run-up,) I’m happy about it. (I don’t recall taking victory laps, but it definitely feels good.)

I follow people who add value to my stream. I wish there were many more like LT, (especially when/if you portray yourself as posting live trades,) he is definitely one of the best. I do however find value in many other people who have different styles as well.

As they say, “suum cuique” or “to each is own”.

- MicroFundy