The Good and Bad of Risk

Since I was a sophomore in college, my passion has been the stock market–learning its history, finding what methods work and don’t work, discovering new indicators, hearing other people’s points of view, you name it, I love it.

Most of all, what I love is the challenge. To put it plainly, making money in stocks isn’t easy. The main reason for that is because the market is a contrary beast; it rises when most people think it will fall (climbing the wall of worry), it drops when most people believe it will rise (sliding down the slope of hope), and individual stocks can gap up on bad news or down on good news. In other words, the market often does exactly the opposite of what makes sense.

That’s why successful investors – the ones who’ve been investing and churning out solid returns for years – have a deep respect for, and are humble toward, the markets. Usually you hear the younger stock-pickers say things like “I think this will double in two months! It’s an amazing company!” while the older, wiser veterans often claim that, “Maybe if such-and-such goes well, the stock will advance for a few weeks.” Less enthusiastic? Maybe. But also more humble, realizing that anything is possible in the market.

(Going along with this is the old Wall Street saying: “There are old traders, and there are bold traders, but there are no old, bold traders.”)

Consider the Risk

Which leads me to Mr. Kerveil, the now-infamous trader at Societe General who lost his bank billions of dollars. Whatever the reason, he decided to prove he was a great trader to his bosses. And how did he do this? By tossing caution to the wind and making huge bets in the futures markets (which are tremendously leveraged). And … he succeeded! In fact, he had traded his way to mind-boggling profits by the end of 2007, because of his foresight and big bets.

However, this is where Kerveil’s lack of perspective got him in trouble. Did he think that, maybe, he could have a bad spell after a tremendous run? Evidently not – the game appeared easy to him. And the result is now making headlines everywhere, as in just a few weeks, this mid-level trader lost everything he had made and them some. He ignored risk, failing to account for it, and in the end, it burned him.

The moral of the story: Successful investors always consider risk when analyzing their portfolio, adhering to rules like cutting losses short (if you’re into growth stocks) or diversification (value stocks). I constantly talk to investors who fail to think of the downside, plowing a huge percentage of their portfolios into a few stocks … and then failing to cut the loss short if things go amiss.

While these investors don’t lose billions of dollars, their portfolios get crushed during even intermediate-term market corrections, never mind true bear markets, which can literally wipe out 50% to 80% of their savings. So remember, even in the best of times, you want to consider how much of your hard-earned money you have at risk, and how you’ll handle your stocks should they head south.

Devise a Loss Limit

Risk, however, is not all bad. Without it, in fact, there would be no profits! But, just as there are too many investors who ignore risk, there are nearly as many who fear it way too much.

These are the people who, after witnessing severe volatility (and, usually, losses) by the market and individual stocks, conclude the game is rigged or something of the sort, and thus, decide to effectively stick their head in the sand and buy just tiny amounts of low-volatility stocks. The result: Guaranteed mediocre returns.

My point is that risk is neither 100% good nor totally evil–it’s a necessary part of investing, so the key is to manage and take advantage of it in your own dealings. Really, this is what the entire investing ballgame comes down to; most investors can find out which stocks are leading the way higher (or lower), but the difference between good returns and great returns comes down to how you handle those stocks … i.e., how you handle risk.

Personally, I tend to run a fairly aggressive portfolio–I generally don’t own more than 6 to 8 stocks at any one time. So, obviously, I’m taking on plenty of risk … my goal is controlling it in a prudent fashion. Here’s a way to do that.

First, you should pre-define the maximum loss you’re willing to take on each trade. Let’s say you have a $50,000 account. You might decide to risk 1% of your portfolio for every stock you buy; that way, even if you lose on five consecutive trades, your overall portfolio would only be down 5%. In this scenario, 1% of the account is $500 ($50,000 X .01).

Knowing that figure, you can then devise a loss limit on any stock you buy. If you purchase $10,000 of a stock, you’d set a 5% loss limit (because 5% of $10,000 is $500). If you instead buy $5000 of a stock, you could have a 10% loss limit. And so on.

From all I’ve read, the best traders generally risk no more than 2% of their overall account per trade, and usually, the risk is more like 1% or sometimes less. So, while we’re all waiting for a bull market to appear, you should take a hard look at your own portfolio and think about what type of risk you want to take on during the next upmove. There is no right or wrong answer, but thinking about this topic ahead of time is like formulating a game plan before a big game – you’re more likely to get off to a good start, and you’ll be able to adjust (if need be) more easily, leading to better results.

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Trend is Not Up

As for the current market, in my view, the onus is still on the bulls. The major indexes slid an amazing 15% to 20% from their December peaks to their January lows. So two weeks of rallying–while welcome–doesn’t mean the overall trend is now up.

Moreover, most of the strength in recent days has come from the most beaten-down areas–homebuilders, banks, brokers, insurers, transport stocks, etc. Actually, the volume flowing into these names is impressive, so I do think there’s a good shot these groups have bottomed, or at least are beginning to form a bottom.

In the growth universe, however, it’s still slim pickings. There are few stocks setting up for any huge advances, and almost all of last year’s leaders are heavily damaged, even after bouncing the past few days.

One example in my book is Monsanto (MON). The stock is expensive by traditional measures–it’s trading at 41 times expected ’08 earnings, despite projected profit growth in the 30% range. And this huge company’s stock is up six-fold since late-2004, and is owned by more than 500 mutual funds.

More important, MON fell 12% in the week ending January 18, and the weekly volume was the heaviest in years, a clear sign big investors were unloading. Shares are inching back up, but this is no set-up worth stalking. In fact, if you’re aggressive, you could consider selling short around here … as long as you keep a protective stop-loss in the 120 to 125 area.

What I’m looking for on the long side are growth-oriented stocks that (a) are holding up relatively well, (b) are liquid enough to attract institutional attention, and (c) have broken out of consolidations relatively recently (in the past year), as opposed to many of today’s most popular stocks, which got going years ago, and thus are over-owned by some measures.

One such stock is Auxilium Pharmaceuticals (AUXL), which has appeared in Cabot Top Ten Report a few times in recent months. The stock broke out in early August of last year, so the advance isn’t overly ripe. The stock trades a little more than 500,000 shares per day on average – a bit on the light side, but the totals are growing. And the stock itself burst into new-high territory last week.

As for the company, it’s an unprofitable firm in the biotech industry, but its business isn’t a pipe dream; Auxilium has one product on the market to increase testosterone levels in men, and also holds the rights to a delivery system that can deliver a drug through the upper gum. Yes, it’s a bit hard to get my arms around the story, but the action of the stock and the firm’s accelerating revenue growth (up 24%, 42% and 49% the last three quarters) tells me to keep an eye on its progress. If you’re game, take a nibble (small position!) on a pullback into the low 30s.

All the best,

Michael Cintolo

Editor’s Note: Michael Cintolo is Vice President of Investments for Cabot Heritage Corporation, and also serves as the editor of Cabot Market Letter. While the topsy-turvy market environment has most investors wondering what to do, the Cabot Market Letter’s time-tested market timing indicators have guided the Letter’s Model Portfolio to superb gains – it was the #6 newsletter in the country during 2007, with a gain north of 35%, compared with less than 4% for the S&P 500; over the past five years, the gain has averaged 19% annually. Mike’s specialty is finding young firms with revolutionary new products that are under-owned by the big mutual funds. If you want to stay in gear with the market, and uncover 2008’s big winners, give the Cabot Market Letter a try.