by Jeff Miller
It has been well documented that individual investors trail the market averages when it comes to investment performance. The “buy and hold” concept has little respect these days, but most individual investors do even worse.
There are many reasons for this, but bad market timing heads the list. As many regular readers know, I have been working on a book aimed at helping individual investors. Part of my approach is explaining how professionals think about problems. Here is one example.
The Concept of Upside Risk
There is a concept well known to financial professionals, but rarely considered by the individual investor. It is the concept of upside risk. Briefly put, it means you have a position that will be a loser if prices move higher. Here are a few examples:
- The most obvious case is the hedge fund manager who is “short” a stock. This means that his fund profits when the stock goes down and loses when it goes up. His risk is to the upside.
- Mutual fund managers try to beat a specific benchmark. When they are partly out of the market, or in very conservative investments, their risk is to the upside.
- When a stock analyst writes a professional report recommending a stock, she lists all of the factors that could be problems for the company. When the analyst recommends against owning a stock, she lists all of the things that might be better than expected. The risk is to the upside.
This is an indispensible concept for the individual investor. It starts with analyzing your personal situation
The Key Investor Question: What is Your Risk?
The average investor thinks only about the downside. Because of our natural human instincts, well established in the psychological studies of behavioral finance, we all focus on what we might lose. This can have a paralyzing effect.
Meanwhile, there is a constant barrage of news about problems. This is the grist for the daily media reports.
Professionals cut through this news. They have a specific market plan, balancing risk with reward. Most individual investors do not have a strong plan — one with a specific target and a process to reach the goal. They often make the mistake of treating their investments like a poker game where they are “all in” — or all out.
The Acid Test
If you have all the money you need for your future, you should be preserving capital. I understand that interest rates are low, but security is important. Be cautious!
Most of us are not in that happy position. We need to create wealth, not just to preserve wealth.
If you have significant future needs, and you do not own any stocks, you have upside risk.
To appreciate the risk you should ask yourself what will you do if the market goes to 15,000? To 20,000? When will you decide to buy? If you do not have a plan, it means that you will miss out in achieving your goals.
Every portfolio needs a balanced asset allocation. The right answer is different for each investor.
The professional investor views risk in terms of upside and downside. The amateur looks only at the downside. He fails to ask decisively when there is opportunity and chases the market at peaks. There is no better time to invest than when there are many well-known and well-documented worries. A bad time to invest is when no one is worried.
This is very difficult to understand, and even harder to implement.
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About the Author
Jeff Miller has been a partner in New Arc Investments since 1997, managing investment partnerships and individual accounts. He has worked for market makers at the Chicago Board Options Exchange, where found anomalies in the standard option pricing models and developed new forecasting techniques. Jeff is a Public Policy analyst and formerly taught advanced research methods at the University of Wisconsin. He analyzed many issues related to state tax policy and provided quantitative modeling which helped inform state and local officials in Wisconsin for more than a decade. Jeff writes at his blog, A Dash of Insight.