One of the things I’ve discussed on my podcast has been how traditional tools used by financial advisors and RIAs aren’t sufficient to get a real handle on our risk.

Risk questionnaires, like the kinds Vanguard uses (one of the better ones by the way), don’t accurately capture our real relationship with risk. There are a variety of reasons why that’s the case but for this post, I wanted to focus on just one aspect of risk and that’s our inability to measure it.

Can you measure risk? The investment water snake

Do you remember those toys we had as kids. These water snakes were latex balloons filled with water and shaped like hot dogs. If you tried, it was super slippery and would just squirt out of your hands.

Risk is like an investor’s water snake. It has the interesting property that the more we try to define it and measure it, the more our own awareness changes, our behavior changes. This forces the risk to move, popping up elsewhere in our portfolios.

In John Adams’ Risk, he writes:

The problem for those who seek to devise objective measures of risk is that people to varying degrees modify both their levels of vigilance and their exposure to danger in response to their subjective perceptions of risk.

The modifications in response to an increase in traffic danger, for example, might include fitting better brakes, driving more slowly or carefully, wearing helmets or seat belts or conspicuous clothing, or withdrawing from the threat completely or—in the case of children no longer allowed to play in the street—being withdrawn from the threat by their parents.

Investment risk is always out there.  Because risk is all about how we personalize and internalize it, our behavior changes the more we become aware of it. Like a water snake, its slippery nature causes us to react differently each time we try to get a hold on it.

The Conservation of Risk: not destroyed, just changes form

The upshot of all this is as we become more aware of our tendencies to make bad investment decisions, we actually become better at what we do. We remove risk from one part of our portfolios, but we don’t totally do away with it. We just force it to show up somewhere else in our portfolios.

If we’re buy and holders, we mitigate overtrading and overconfidence — both related and really bad for our performance. But by holding through tumultuous investing environments, we may actually be too exposed at a given point in time. See, we’ve solved one problem by creating another.

This is like its parallel in physics. Matter isn’t destroyed, it just changes form.

Risk on, baby.

He’s done perhaps the deepest research into different sentiment indicators in the stock market. He’s got so many emotions to describe the activity in social media that it sounds almost like he’s anthropomorphized the markets and market chatter.

Here’s one tool I think is particularly cool. His firm is out culling for measures of positivity. He’s then plotted that measure over recent stock returns to get a measure of overbought and oversold, depending where the stocks plot out. Almost like crowdsourcing investment ideas — but really doing it.

This chart updates every morning with new stock picks but the idea here is that you’re looking for divergence in sentiment — where sentiment breaks off from actual stock performance. You’re going to want to look in the upper right and lower left “quadrants” of the graph.

Been talking to a lot of investing people about Risk recently: what it is, how to measure it, how to control it.

Why Risk matters

Risk is one of those things you don’t realize you have too much of until it’s too late. Being able to manage risk effectively is essential in the investment process.  Get it right and you hit your goals. Get it wrong and the potential for catastrophic losses is immense.

I don’t agree with the buy-and-holders who believe holding forever erases risk. Risk is always there, lurking around the corner.

There are huge issues and ones that many academics and entrepreneurs are beginning to tackle in meaningful ways. Imagine if we can get to a point where we can personalize risk — with financial advisors and with DIY investing tools.

What is Risk

From the literature I’ve been reading, Risk is one of those terms whose meaning few agree on. And like many Eastern concepts, it’s frequently an evolving concept, defying being captured by a single definition.

In fact, Risk may best be described (not defined) by what it’s not.

I happen to like what Zvi Bodie in Risk Less and Prosper: Your Guide to Safer Investing does with Risk:

Let’s discard the idea that risk is nothing but the unknown, because risk is more than the ordinary uncertainty that surrounds our lives. By referring to harm, loss, and fear, the next three suggestions reflect one fundamental property of risk: Somebody has to care about the consequences if uncertainty is to be as risk.

The notion of “caring” or “mattering” is central. It captures both the potential (objective) impact of uncertainty as well as its (subjective) bite. This brings us close to the definition we’ll adopt: Investment risk is uncertainty that matters. There are two prongs to this definition—the uncertainty, and what matters about it—and both are significant.

So, beyond the odds of hitting a rough patch, there are the consequences of loss to consider. What will happen if you miss your goals? If you look to your goals as benchmarks for measuring risk, you’ll deepen your appreciation of what goals make sense for you.

Investment risk is two-headed Hydra beast thing

There are two sides of risk:

1. uncertainty: one is our inability to accurately forecast the future. That uncertainty means as investors, we have to use specific tools to avoid or soften the blow of the unforeseen.
2. personal impact of getting it wrong; If you get investing a little wrong, no worries. But screw up planning for you retirement on the eve of the next stage of your life, and well, you’ve got a big problem. My Dad likes to joke, “I’ll just work until I die…”

Investment risk had been glossed over in the past. It’s easy to look like you’re performing well when the market just goes up and up. Long-term though, it’s really your risk-adjusted returns that matter.

That’s something the advisory world hasn’t paid enough attention to and something individual investors haven’t even had the language or tools to address.

That’s changing.

Life = Risk

Photo by kyz

You’ll learn about:

• recent Harvard research that shows a new insider trading strategy produces 10% of abnormal returns — per year
• how to identify the smart insiders (versus other noisy trading)
• the methods to create a portfolio that mimics some of the best
• other ways to play insider trading (funds, ETFs)
• the best online tools and resources to bubble up insider trading that really means something

Interested in attending?

>>>Sign up here<<<

Not only do I rely upon it for email, video, and of course, search, but I’m using it to invest  better and smarter (the Tradestreaming way, right?).

Let me explain:

One of my first podcasts on Tradestreaming Radio was with finance professor, Joey Engelberg. In How to use Google search data to invest, I asked Engelberg about a paper he had recently published that showed how useful Google could be in forecasting stock prices.

Using Google Search Data to Invest by tradestreaming

Specifically, Engelberg noticed:

1. Google search volume likely measures the attention of retail investors
2. and does so in a more timely fashion that existing proxies of investor attention

And of course, stock prices tend to follow attention.

So, an increase in Google search frequency (SVI) predicts higher prices in the next two weeks and also contributes to a large first-day return (and long-run underperformance) of IPO stocks.

Awesome stuff and after we spoke, Joey kind of went underground (he did leave UNC and headed for UCSD), using his research to make coin at a hedge fund. I spent a whole chapter in Tradestreaming (my book) describing co-lateral research — stuff that’s inherently non-financial in nature (Google search, Amazon ratings, etc) to help us make better investing choices.

Now a new paper shines light on how Google search reflects investor information demand and what that means for earnings news.

Google can predict an earnings pop (or lack of)

In Investor Information Demand: Evidence from Google Searches around Earnings Announcements, a trio of researchers found that

abnormal Google search increases about two weeks prior to the earnings announcement, spikes markedly at the announcement, and continues at high levels for a period after the announcement

So regardless of the availability of news, PR, and financial portals, investors use search to access financial information and news about stocks.

What it also means — and this is the bigger takeaway from the paper — is that a lot of searches conducted prior to an earnings release have the effect of preempting the actual news.

In plain English, if investors spend a lot of time searching information before a firm releases its earnings, the less they’re surprised when the earnings are released. It dampens the effect (or “preempts” them, as the authors of the paper call it).

• So, abnormally high search activity –> potentially minimal earnings movement
• lower search volume –> more potential for a pop

Here’s an example from Microsoft’s (MSFT) search volume in 2006:

While interesting, this info isn’t quite actionable yet as an investing strategy for individual investors. But it’s definitely an important data point to use if investors are playing earnings or thinking of bailing before an earnings report.

And those findings make sense, right? Investors are doing the work and that aids in price discovery, leaving less potential to be surprised.

Check out Google Insights for Search and see what’s going on in your favorite stock.

More Resources

Here are some of the leading research papers on how Google can help investors make more informed — better — decisions.

For those of you who’ve been following Tradestreaming for the past couple of years (and read my book), you know that I’m a fan of following the smart money.

By following the tradestream of hedge funds or the activity of corporate insiders, investors can create portfolios  and strategies that have at least been proven in the literature to make money.

Insider trading is a treasure-trove of potentially-profitable information. Top managers at their firms are in the best seats to determine the future prospects for their stocks. If they reach into their wallets and buy their firms’ stocks, well, that’s an incredible useful signal.

An insider trading blueprint

There’s been some amazing research into insider trading. Recent studies have found that investors can mimic the returns of insiders to beat the market by 7 – 10% a year.

I wrote the 20+ page, The Harvard Guide to Insider Trading to describe these strategies and provide a quick blueprint to create portfolios comprised of the most useful insider trading.

AND, to teach you how to use insider trading strategies for your own trading/investing.

You can download it freely here.

I hope you like it — let me know (via email or in the comments) what you think.

It’s deals and partnerships that are driving the growth of many of these top online finance startups.

I went through this list and named the top biz dev people in Finance 2.0. But the list is very incomplete — who do YOU think belongs on the list? 

Who’s the top business development person in online finance?  Vote below.

Sh*t investors say

1. “I want to turn $100k into $5 million”: Possible? Yes. Likely? No. It’s a real discussion going on on Quora now. The best way to grow a portfolio is by continuing to add to it (even better if your employer can match — that’s free money). To get 75% compounded returns, I personally like the answer to buy a $7 million life insurance policy and have an “accident”.
2. “But Suze Orman says to…”: I hear this one a lot. It’s best not to have gurus. Not Suze. Not Dave. Not me. These guys are great to learn from. Go ahead and glean. The good ones are great teachers and offer great learning opportunities. But they’re out to build their own businesses. And as we’re learning in SuzeOrmanGate (my term), they’re liable to sell you stuff that’s just not good for you. I’m not picking on Orman — she’s done great things for people. But gurus are human and stumble sometimes.
3. “This investing stuff is easy”: No, it’s not. Sure, clicking buy or sell on your online trading account is pretty simple but the act of investing — planning, risk management, asset allocation — is hard. At least just for the fact that much of the process requires us to fight against our natural, human inclinations.
4. “This strategy is a printing press — it always works”: Strategies work until they don’t. Many strategies, like my hedge fund piggybacking strategy, was developed by backtesting results. I don’t expect it to EVER work as well as the results because I designed it to maximum those results.
5. “Well, Buffett owns it”: Hey, I’m a big fan of following the smart money. Heck, hedge fund replication strategies are built upon the idea that they know more than we do. But don’t ever confuse a single stock pick for an investment strategy. When Buffett buys something, it’s a piece of a larger pie, an additional piece in an investing puzzle known only to him. Beware of cherrypicking guru stock picks.
6. “You should check out this hot little small cap I just bought. I’m up 100% already”: OK, tough guy. I’d like to see your cost basis on this one. Not that I accuse you of lying but people stretch the truth when talking about their winning ideas. They also don’t happen to mention the ones that they got wrong. Unless they’re audited results like Chris Camillo posted (he turned $20k into $2M — I guess they could be forged), take these claims with a very large bucket of salt.
7. “You should really subscribe to this penny stock newsletter I get. Great info”: Investors — many smart, educated people — turn their brains off when they subscribe to free or premium newsletters. Many blindly swing at every pitch. The penny stock newsletters are published by stock manipulators. They get paid by large investors to prop up prices, so they can exit their positions. Many are compensated in stock, which incentivizes them to pump ‘em up.
8. “I’m out! This market is rigged.”: Well, it might be but it still plays by some rules. Insiders have always profited — leveling the playing field with REG FD (requiring public disclosures of important information) didn’t change that. But use the tilt in the field to your advantage. Mimic the insiders and create strategies that follow their trading. I just wrote a free ebook: The Harvard Guide to Insider Trading that describes this technique.
9. “I don’t know what to do — my broker sucks a$$”: He might. Many do, but there are plenty of trustworthy good financial professionals (yes, even brokers) out there. They put their clients first not matter whether they have taken the fiduciary duty or not. But if you’ve had bad luck, keep looking. Try an online advisor like Covestor (I do freelancing work ) or Personal Capital. or Wealthfront (I’m a freelance writer).  Use Wikinvest portfolio tools (I’m an editorial contributor) or portfolio optimizer, Jemstep. I especially like what Hedgeable is doing. Don’t be complacent – there are new solutions out there that may just work better than the old ones.
10. “My friends and I are getting into a small real estate deal. We’ll let you in if you behave.”: Sounds like an investment cult to me. If they’re really your friends, I’m not sure you’d have to beg to get into a small deal they’re putting together. Friends get burnt all the time by getting sucked into sucker deals. That doesn’t mean to take a pass on everything that comes your way but it does mean to be very, very, very, very, very picky about who and what you invest in.

photo by indi.ca

He’s the author of the very useful The Wall Street Professional’s Survival Guide

In this week’s episode of Tradestreaming Radio, you’ll learn about:

• where the jobs are headed on Wall Street
• what successful candidates are doing to land their dream jobs
• common mistakes people make with their financial careers
• traits shared by top performers

Awesome opportunity

Roy is also joining me at the 4 Days to a Better Job: 2012 Finance Career Bootcamp. You’ll get access to Roy and 8 other experts to literally supercharge your job search. Great if you’re trying to break into Wall Street, hedge funds, etc and equally useful if you’re in the market for a better job.

Loyal listeners of my podcast get an additional 25% off  - if you sign up before January 31. Use the special code PODCAST  to get your discount. Go here to buy your tickets.

Listen to the FULL program

How to plan an awesome career in finance by tradestreaming

About Roy Cohen

Roy is a career coach on Wall Street and he author of the very useful The Wall Street Professional’s Survival Guide

Read the Transcript

Get your own transcript at Speechpad

More resources

• The Wall Street Professional’s Survival Guide (Roy’s book)
• Roy Cohen’s professional website

Even More Resources

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