It may sound odd to investors to consider upside risk as a threat to their stock portfolio, but the risk is real! Although the risk that an investment goes up is to be welcomed, it is useful to analyse what can happen if you miss a market rally. Being late to the (investment) party can lead to poor decision making, which can come back to haunt you.
Key Takeaways
What is upside risk
How it can work against you
Solutions to control your emotions
What is upside risk?
Upside risk is the possibility of gain with the risk that this does not happen and you lose money. If you fail to take advantage of an opportunity, you may feel compelled to rush in when it is too late, possibly assigning too much capital and creating large losses for yourself. It brings the potential to cause bad decision making.
Why is it important?
When investors talk about risk, they focus on downside risk, which can lead to disappointment, frustration and regret. Such disappointing emotions, which are part of investing, can make a losing investor quit investing.
Emotions are a powerful component of making an investment decision, but until recently were not given enough consideration. If an investor fails to consider upside potential, this can also lead to disappointment, frustration and regret – but with the difference that they have not actually lost any capital. They have just lost the ability to grow their capital.
The upside risk dilemma
You will face situations as an investor where an opportunity looks compelling, but something will hold you back. Cryptocurrency trading could be an example. Many missed it. This can be because of a risk or maybe a bad experience. Maybe this is a highly rated stock by analysts and retail investors, which has been growing rapidly, but is on a expensive valuation.
Should you buy or should you accept you have missed out? The investment is in a field which is growing, but will the profits keep growing? Checking the financial statements will help, but this may not give you a clear idea of what to do.
How upside risk can be missed
S&P500: 12 month view on the daily chart.
It takes a a brave person who thinks doubling down is a good idea when you have just had one of the worst sell offs in recent memory. Yet it is arguable that this is when the upside risk is at its greatest. Momentum investing is a lower approach than momentum trading. Few portfolio managers were buying the S&P500 at the March 2020 lows, with retail investors seemingly the ones to jump in and enjoy the rally. Remember, being greedy when others are fearful is something that Warren Buffet has often espoused.
Reduce your risk to benefit from upside risk
If you believe that a stock has more upside that downside, you will be tempted to buy into it. Sometimes a share is worth a risk if you have done the fundamental analysis to understand what is the risk reward.
The greater the risk, the smaller the position you should take. Maybe putting in a ‘blocking’ position is a good idea. One small enough that if the shares go down, you do not lose too much capital, but allowing you to benefit from any upside. This is an example of giving yourself a margin of safety.
Discipline will help you.
If you own some hot stocks you will likely see some share price gains very soon. But just as a momentum trading can go up, it can also come down. Taking profits regularly, such as reducing your holding, is the best of both worlds. If the shares keep going up you will benefit, if the shares sell off you have banked some profit.
Conclusion
If an investor has failed to spot upside risk their choice will be both a strategic and/or tactical one. If a share which an investor was considering investing in has jumped upwards (Tesla stock?!) after a positive statement, should they give up buying in? There is no clear answer to this question, as it depends on what kind of investor you are.
Experienced disciplined investors will likely walk away, because that is the investment style they are comfortable with. Flexible investors who have the risk tolerance to trade, may believe they can eek out a quick 10% profit by riding the momentum.
What you should never do is to invest based on fear of missing out or having missed out. Trader’s regret is a dangerous emotion and should be banished from your thoughts. Fundamentally, knowing what your investment style is and how your emotions affect your decision making, will ensure you do not let the downside to your upside risk torpedo your portfolio’s performance.
Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.
Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.
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