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Don't Get Roasted: Breaking Down Stock Market Risk (for Real)

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July 1, 2015
stock market risk
Fredrik Broden

Long term. In the financial world, the phrase is usually teamed with “investor” to describe a per- son who buys stock and patiently holds it for a “long” time, maybe years or decades. No taking of profits. No stop losses. Maybe the occasional reallocation or reinvesting of dividends. Above all, the goal is to have steady, compounding returns over time—the hallmark of a successful, albeit traditional, investing career.

Long-term investors often have a “set-it-and-forget-it” approach to their positions. But investments aren’t rotisserie chickens. The consequences for overcooked chicken aren’t quite as serious as assuming your investments will take care of themselves. That kind of mistake can mean overlooking risk—something professional traders have a deeper understanding of. Here we’ll explore three kinds of risks you’ll need to understand if you’re a long-term investor hoping to think more like a trader: systematic risk, non-systematic risk, and, well, let’s just save the third until the end.

RISK 1:

SYSTEMATIC RISK

Systematic risk, or market risk, describes what happens when all stocks rise or fall based on some external factor—like a change in interest rates, problems with European debt, or unemployment numbers. This is the risk of the market overall, not just a particular industry. For example, bank stocks, tech stocks, and energy stocks represent very different industries. But think about what happened in 2008. Based on the fears of a global financial meltdown, all stocks dropped, regardless of industry or sector. That’s a straight shot of systematic risk. But surprisingly, this kind of risk doesn’t affect all stocks equally. In 2008, as it played out, some stocks dropped a larger percentage than others. How do you account for this disparity when assessing portfolio risk? Think like a trader.

Beta for assessing longer-term risk.

We use “beta” to measure how much systematic risk a stock has. Let’s explore that. The S&P 500 is a large, diversified stock index reflecting a wide range of industries and sec- tors. That’s why the S&P 500 is considered a performance benchmark. Now, for example, when the S&P 500 moves up 1%, a bank stock moves up 0.75%, and an energy stock moves up 1.5%, the bank stock has a beta of 0.75 (i.e., less risk than the S&P 500), and the energy stock is said to have a beta of 1.5 (i.e., more risk than the S&P 500). A stock beta indicates how much the price of the stock might change (in percentage terms) when the S&P 500 (or another benchmark) changes by 1%. Beta, in other words, is a measure of the stock’s volatility—its risk—relative to a benchmark.

You can see a stock’s beta in TD Ameritrade’s thinkorswim® trading platform by going to the Trade page (see sidebar below, “How to Get Better Beta”). By default, the beta in thinkorswim uses five years of data to calculate systematic risk. For a shorter term of one year, you may want to switch to “Fast Beta,” which can be found in the Applications Settings box (Figure 1), which you’ll find under the application’s Setup menu in the upper right of the platform. Switching the beta method sets the beta you’ll see on the Trade page, as well as sets the beta used in the beta-weighting tool on the Monitor page.

GETTING A FASTER BETA.

FIGURE 1: GETTING A FASTER BETA. To get a one-year beta (instead of the default five) in thinkorswim, go to the Application Settings in the Setup menu of the platform. For illustrative purposes only.

Beta-weighting for a “truer” measure.

This tool adjusts your position’s delta (the amount your position moves—typically an option) by the stock’s beta so you can compare the deltas in terms of a benchmark like SPX.

Say you’re long 200 shares of XOM*, 100 shares of AAPL, 300 shares of MSFT, etc., with your position deltas equal to their number of shares. While delta is a measure of risk, you can’t really compare position deltas directly because each stock has a different level of systematic risk. When you apply the beta-weighting tool with, say, SPX as the benchmark, you might see that XOM has a beta-weighted delta of 50, AAPL 75, and MSFT 20. So in S&P 500 terms, your portfolio theoretically has more risk in AAPL than it does in either XOM or MSFT.

How to Reduce Systematic Risk.

So as a trader, what do you do with this information? In the case of individual positions, unless you’re more confident in your bullish opinion of say, AAPL, you might want to bring its beta-weighted delta down closer to the others by reducing the number of shares, or purchasing a put, for example. For your portfolio with too much systematic risk, you might reduce the portfolio deltas with defined-risk, negative-delta strategies, such as short call vertical spread, long put vertical spread, or others in the benchmark product.

Taking the beta-weighted delta one step further, you can see the portfolio’s total delta at the bottom in terms of the benchmark. It gives you your portfolio’s systematic risk, which is the dollar amount of profit or loss that would theoretically occur if the benchmark moved $1.00. Are you comfortable with that amount of risk? A set-it-and-forget-it investor wouldn’t think about it. But keeping track of your systematic risk can potentially help you avoid a nasty loss in another crash.

RISK 2

NON-SYSTEMATIC RISK

Non-systematic risk, or industry- or sector- sensitive risk, is stock risk not predicted by its beta. For example, if a stock has a beta of 1.5, and the S&P 500 moves up 1%, theoretically the stock price would go up 1.5%. But if it goes up 1.4%, that 0.1% difference can be accounted for by non-systematic risk. Non-systematic risk is what happens when one stock is dropping sharply while the rest of the market is up. This often happens around earnings announcements, industry news, or other corporate events—effects that don’t always show up through the lens of the beta tool.

How to reduce non-systematic risk.

Theoretically, you can diversify to help reduce non-systematic risk. The S&P 500, for example, doesn’t have a lot of non-systematic risk because the impact of one stock, or even one sector, on the index as a whole isn’t that large. So, the long-term investor can seek to reduce non-systematic risk with index products, or a portfolio of individual stocks, from a broad range of sectors. By contrast, a trader hunts down the very things that might cause non-systematic risk. The Calendar tab on the MarketWatch page of thinkorswim shows upcoming earnings events, for instance (see Figure 2).

CHECK YOUR CALENDAR

FIGURE 2: CHECK YOUR CALENDAR. Look at the “Calendar” feature in the MarketWatch tab of thinkorswim to be aware of potential non-systematic risk that could be lurking in the future. For illustrative purposes only.

Knowing when news is coming for a specific stock, or housing numbers, or petroleum data that could impact whole sectors, could let you hedge the stock before the news comes out. In this way, the long-term investor can potentially reduce non-systematic risk more directly.

RISK 3

YOU, THE TRADER
You  can’t predict systematic or non-systematic risk very well at all. You can try to mitigate them, but can’t control them. But there’s a third kind of risk that financial theory doesn’t cover, and which is entirely under your control. You. How can you be a risk to your own portfolio, you might ask? In a word, position size. Or more specifically, having a position in a single stock significantly larger than any other. If that stock has a correction, could it create an unrecoverable loss in your account? A “too-big” position in a long-term investor’s account could reflect an unlucky combination of systematic and non-systematic risk with potentially significant downsides.

How to save you from yourself.

Be objective. No matter how attractive and tempting one stock’s shares might be, your analysis may be imperfect, and remember that money doesn’t pick favorites. In a word, take your bias out of the equation. Keep the risk of any new trade roughly the same size as the others. And that will free you up to better manage systematic and non-systematic risks, while not burning down your house trying to perfect a rustic galette with turkey sausage, eggplant, tomato, and ricotta.

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