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May 30, 2012 – Comments (0) | RELATED TICKERS: FB

Board: Facebook

Author: trader2012

Managing risk is the essence of investing.

Before FB came to market, it could not have been known for sure that the price wouldn’t pop, creating instant, easy wealth for anyone who bought in. The odds were against that happening, for a wide variety of well-known, technical and fundamental reasons. But it couldn’t have been known that the price wouldn’t pop. What could have been known (and was widely known) was that the more favorable market-side was short, not long. That was the higher probability bet. But those who liked and used FB wanted to buy into the IPO, and they said they didn’t care if they initially lost money. Well, they are getting exactly what they wished for. They own shares, but those shares are now worth 24% less than they paid for them. As we go into the close on May 27, the BID is $28.70, which is a tad bit down from the IPO price of $38, suggesting they weren’t investing when they bought. They were merely gambling, and now they don’t have the honesty to admit that, nor, retrospectively, the common-sense to have set a stop.

So, let’s review what should have been done, so that lessons can be learned by which future mistakes could be avoided.

Whether it’s stocks, bonds, or whatever that are being bought, once the decision has been made to buy something, the next question is “How much?” If a reasonable guideline is that no position should be more than 5% of AUM, then buying 100 shares of FB at $38 would presuppose an account size of $76,000, or very close to the median net-worth for all investors. OK, so far, so good. To put on a 100-share position wouldn’t have been an outrageous thing to have done. The position wouldn’t have been too big. It would have been merely one of presumably nineteen other stock positions already held, and owning FB in that amount would have fallen within the customary rule of thumb that suggests that 20 positions, spread across industries, creates reasonable diversification.

But let’s say our would-be investor were convinced he or she was the next Warren Buffet, who scoffs at diversification, calling it “diworsification”. So let’s say our intrepid investor went 500 shares, arguing (not unreasonably) that “mere exposure isn’t the same thing as risk.” Well, that’s true, but such a statement presupposes that risk can be measured. In this case, it easily can be. Risk is the size of potential loss times the certainty of it occurring. But if you can’t quantify ‘likelihood’ (and ‘gut feeling’ isn’t quantifiable), then you have to assume that likelihood is a coin flip, and you have to focus on the other half of the equation, the size of the potential loss. That, too, cannot be known in advance, but limits can be set. In his books, William O’Neil suggests that 8% is a reasonable hard stop. “When a position moves against you by that much, you should assume that you made a mistake and get out.” Had the Facebook gamblers set hard stops at $35 dollars, they would have been kicked out around that price, suffering an (-8% loss), instead of the (-24%) loss they are now facing (and still don’t know what to do).

Everyone has a different account size, and everyone has a different emotional response to risk. So, hard and fast rules cannot be so easily suggested as O’Neil’s 8% guideline. But it’s very easy to run one’s own numbers in a spreadsheet and to determine where the limits are. Sometime, when you’re considering an investment, you might want to do just that. Rather than focus on how much return it might offer, you might want to focus on how much loss it could cause. If you can‘t see a way to manage the risk, you have to back way and look for a different opportunity. But if you can see a path to managing the risk, then a position can be sized and the order written.

The investment might work out, and it might not. But you won’t get yourself thrown out of the game for having over-bet your hand. Those who over-bet their account and who bought more of FB than prudence suggested they should are now suffering the torture of their greed and stupidity. Those who put on prudently-sized positions and set hard stops are now on the sidelines, waiting for the dust settle, and, if they choose, they can get back in at a much better price. Stocks or bonds, investment losses cannot be avoided. But they certainly can be controlled, and must be controlled, if capital is to be appreciated, instead of merely being spent on the emotional thrill of owning an IPO.

“Amateurs look first to their upsides. Pros look first to their downsides.”

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