To Understand Risk, Start By Asking What You Don’t Know

FinanceTrading / Investing

  • Author Toby Carrodus
  • Published September 24, 2024
  • Word count 862

There are now more than 6.6 million Australian investors who own shares on the Australian Stock Exchange, which translates to about 35% of the Australian adult population.

This is not a bad thing, because it means that Aussies want their savings to grow and they’re willing to put their money into publicly-listed businesses and exchange traded funds to earn better returns.

What does concern me is the amount of non-professional people investing in publicly-traded markets, without a proper grounding in investing. And without a solid background, self-directed investors can easily be driven by the wrong questions.

For instance, an amateur investor asks ‘how much can I make?’, while a professional asks, ‘what are my risks?’ The self-directed investor asks ‘what do I know?’ but professionals filter their decision-making through the lens of ‘how much certainty do I have in what I think I know?’

I’d go as far to say that professionals can usually tell if someone is outside their world because they claim to ‘know’ things that in the professional’s mind is a piece of market intelligence to be treated with scepticism.

I frame my own trading through a lense of certainty, which I encourage self-directed investors to think about. Here is a simple way to think about it:

  1. Most certain – Costs: Your greatest certainty in the investing game is that someone will charge you to make a transaction or take a position. Costs you can be certain about include broker fees if you’re buying and selling shares – and remember that they charge you on both the buy and the sell; the bid/offer spread when transacting in the market; ongoing management fees, if you're buying funds; finance costs if you’re using a margin account; and the three layers of costs that you encounter in ETFs – the management fee, brokerage and a performance fee in some of the ETFs. You can put these costs in the debit column before you even take the position. They are high-certainty.

  2. Less-Uncertain – Risk: while your costs are high-certainty, your risks can go either way. In fact, the fluctuation between losses and gains in markets, is called volatility. You can calculate risk by looking-up or calculating the volatility on an asset, a group or sector of assets, or an index of assets such as the ASX200. This will help you gauge whether the moves in a certain market are large, or just part of their normal daily fluctuations. Professionals go further and compare entire markets to one another and look for asset correlations and discrepancies in their portfolios. However, these metrics are still all estimates. You still don’t ‘know’, you are just less-certain.

  3. Uncertain – Alpha. Your alpha is your expected returns from your trading. You can estimate it by looking at the returns of strategies similar to yours, or by examining the historical data of your trades. You can apply maths to this question but your Alpha is generally considered the least certain component of an investment strategy. Many self-directed investors are confused about this, because they start with how much they expect to make. Actually, as a trader your focus should primarily be on managing your trading costs and assessing your portfolio risk. Once you have these factors under control, your trading stands the best chance to extract whatever returns you can from the market.

One way of assessing the quality of your trading is the Sharpe ratio, a risk-return metric that measures the ratio of your average returns to your average level of volatility. It essentially tells you how much volatility you have to endure per unit of return. The 100-year Sharpe of the S&P500 for instance is 0.3. This means that for every 10% of volatility in the market, the S&P500 ekes out on average a 3% return. Professionals are expected to have a Sharpe ratio of at least 1.5, meaning for every 10% in volatility they experience, they need to generate an average 15% return. This is just the lower bar though: many professional prop traders have Sharpes of 3+.

Lastly, I like to caution people to remain humble or the market will humble them. I would add this advice: you can’t control the market, but you can control your costs and to a certain extent your risk. Apart from these two components, you take whatever the market will give you.

And yet, so many new investors go straight for the lure of Alpha, forgetting to nail down what they can be certain (or halfway certain) about. Alarmingly, many self-directed investors aren’t aware of their trading costs or risk estimates and don’t even have historical data on their own trading. Such information is crucial to assess the extent to which you have an edge, or if you even have one at all. This is a great place to start, because if you don't have an edge, you’re better off investing passively in a market index. You’ll do better there than dreaming of Alpha.

Toby Carrodus is an Australian professional trader who has worked in London, Frankfurt, Sydney and Los Angeles for some of the world’s largest hedge funds and asset managers, such as PIMCO and Winton Capital.

Toby Carrodus is a quantitative finance professional focused on medium-frequency systematic global macro trading. He uses statistical methods and automated algorithms to systematically trade bonds, commodities, currencies and equity indices across Europe, Asia and North America.

https://www.tobycarrodusscholarship.com.au

https://www.tobycarrodus.com

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