How is Risk Calculated in Stock Investing?

Calculating risk is an involved topic. You can go on and on identifying and mitigating risk. Of course, you have to reach a point that you stop analyzing and deem an investment worth the risk. We're going to look at what goes into that assessment by using a top-down approach. 

Analyzing a stock investment for risk is not much different from how a real estate investment is analyzed for risk. You start by identifying a few properties and narrowing them down based on their potential vs. their risk. Then you dig deeper into the last few candidates to make a decision. We'll apply those same tactics to stock market investing. For clarification, this article is about long-term investing rather than day trading.

Fundamental Analysis

There are two main schools of thought when analyzing stocks. They are fundamental and technical analysis. They are the first steps in assessing stock risks. These two steps help narrow down the field.

Fundamental analysis looks at a company’s financials, the potential within its market, and its management. It requires an understanding of financial statements, various industries, and knowledge of current management along with their track record.

When looking at a company’s financial statements, we want to know if the company is profitable, growing, able to service its debt, has consistent cash flow, and is overall financially strong. Fundamental analysis uses ratios such as EPS (earnings per share), the quick ratio to measure short-term liquidity, and the debt ratio. Additionally, analysts' projections are taken into consideration.

Industry analysis looks at the broader economics of the industry and the company's place within it. Is the industry growing? Is it cyclical? How does the company rank amongst its peers? Does this industry have high costs? Are its average profit margins high or low?

Management analysis tells us if the management team is making good decisions. We want to know how team members performed at previous companies and how much experience they have.

Fundamental analysis can be said to be on the opposite end of the analysis spectrum from technical analysis, which we’ll look at next.

Technical Analysis

Technical analysis is sometimes referred to as chart analysis since that is where most technical analysis is done. By looking at a stock chart, you can glean a lot of information. Some things to look for in reference to the stock price are:

• Is it going up, down, or is it flat?
• Is it above or below major resistance/support?
• Is it moving on large volume?
• Is it above or below the 50-day and 200-day moving averages?
• Is the stock volatile?
• What is the stock’s beta (another measure of volatility)?

When looking for major support, you are searching for areas that the price went down to and held, then went back up. It's the same with resistance but in the other direction — the price hit an upper level and turned back down. Prices moving up or down with larger than average volume can show interest at those levels. The 50-day and 200-day moving average lines are closely followed by investors and are considered areas of support (if the price is above) or resistance (if the price is below).

Factoring in Risk

After narrowing down some stocks using fundamental and technical analysis, a lot of risks have already been identified. You aren't simply picking stocks by throwing darts at the wall or basing them on the latest headline. Now we can dig a little deeper to see how some stock picks affect a portfolio from a risk perspective.

With some viable stock picks, it’s time to analyze their impact on a portfolio. From the fundamental analysis, we conclude that Stock A is financially strong. From the technical analysis, the stock is not cratering and has been in a long-term uptrend. Things can get complex from here.

With a potentially viable stock, how much of the portfolio should be allocated to its position? In general, no position should be allowed to adversely affect a portfolio. If Stock A is allocated 50% of the portfolio and then drops in price by 50%, that will be catastrophic for the portfolio. To minimize the negative potential of any particular position, its size can be reduced. Reducing from 50% to 10% means that Stock A will have less impact on the portfolio.

By adjusting position sizing, we are affecting idiosyncratic risk. This is risk associated with a specific stock. Systematic or market risk isn’t something we cannot adjust for. 

If we’ve done a good fundamental and technical analysis and deemed Stock A viable, why not just allocate 50% or even more? After all, isn’t this a winner? Just because we’ve done fundamental and technical analysis doesn’t mean we have a winner. It just means that we’ve removed some initial risk. We can’t predict the future and don’t know if Stock A will drop by 50%. We have to accommodate a negative outcome regardless.

That's where adjusting position sizing is essential. We may believe that all of our picks are very good due to our initial analysis, and they may well be. But we also can't predict the future, and therefore, we must accommodate it through position sizing. Adding a new stock should also consider its correlation and position size to other stocks in the portfolio.

We have not considered some critical factors in our risk assessments: the investor's age, goals, and risk tolerance. All must come into play when choosing stocks and calculating their risk. A young investor may be fine with a more risky stock while an investor approaching retirement is not. Risk tolerance or risk profile is very important to determine when investing in stocks. By working with a financial advisor, you can determine your risk profile for stock investing.