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Risk Analysis

Introduction to Risk Analysis

Risk Analysis - Introduction - picture of risk analysis also known as risk management with investor pointing at risk sign in large capital letters on a glass panel

Risk analysis of stocks, which is also known as risk management, is an important component of stock investing. While fundamental analysis is performed on a company in order to determine its future profitability and hence its stock price appreciation potential, risk analysis is performed to manage the risks associated with stock investing.

Thus, fundamental analysis determines the company's profitability and risk analysis determines the stock investor's profitability.

While it is comforting for the stock investor to assume that the fundamental analysis they diligently performed on a stock will lead to their expected outcome, the reality is that fundamental analysis does not guarantee that the company's future earnings will materialize as expected or indeed that the stock price will appreciate as anticipated.

Fundamental analysis is only a tool that is used by stock investors in order to determine the likely future outcome for the company's earnings. Without risk analysis, the stock investor has no idea whether their portfolio will be profitable in the years to come. Investing based on hope rather than quantitative analysis is the prime reason why investors lose heavily when the first market correction comes along.

Pricing Behavior of Stocks

It is prudent for the stock investor to first thoroughly understand the pricing behavior of stocks, as this provides a sound basis for understanding risk analysis. Specifically why stock prices react and fluctuate the way they do, which is often contrary to what is expected to happen. Pricing behavior of stocks deals with the following:

  • Why Stock Prices Fluctuate
  • The Stock Price Roller-Coaster Ride

Once the investor has a grasp on these concepts, risk analysis will make more sense.

Risk Analysis Techniques

Risk analysis incorporates a number of quantitative analysis techniques as follows:

  • Risk Reward analysis
  • Market Cycle analysis
  • Portfolio Diversification
  • Stock Position Sizing

The following articles in this series on risk analysis will go through the pricing behavior of stocks and the risk analysis techniques, which will allow the stock investor to make a more informed investment decision based on risk management.

Why Stock Prices Fluctuate

Beginners expect market prices to move up in straight lines - not bounce up and down

Risk Analysis - Why Stock Prices Fluctuate; picture of a road sign with a yellow background saying volatile road ahead for stocks in black writing

All stock investors will have noticed that the price of a stock tends to fluctuate considerably, even though there has been no change in the stock's fundamentals. These fluctuations come about due to the continuing changes in the perception investors have of what a stock's future earnings will be and their confidence that those future earnings will be achieved.

These perceptions are driven by their emotions rather than by logical reasoning. When investors' perception is positive, they tend to be overly optimistic and are willing to pay extraordinarily high prices. When their perception is negative, they tend to be overly pessimistic and are willing to sell their stocks for ridiculously low prices. To illustrate this irrational reasoning, a $30 stock can rally to $35 and sell down to $25 in a matter of weeks (if not days) even though it's fundamental valuation has not altered.

There is a continuous tug-of-war that goes on with the stock's price as those investors that are pessimistic about the stock are willing to sell down the stock, and those investors that are optimistic about the stock that are willing to drive up the stock's price.

Thus if more investors are optimistic about the stock's future than those who are pessimistic, then the stock's price is driven higher. Conversely, if more investors are pessimistic than optimistic, then the stock's price will be driven down.

The one thing all stocks have in common is that their share prices spend considerably more time above what their realistic valuation is than they do below it. The term realistic valuation is used since it is common practice for investors to manipulate the valuation techniques (especially with the discounted cash flow method) in order to justify a high stock price.

There are numerous factors that can lead an investor to being optimistic or pessimistic. The following discusses these issues and how they affect the view that investors have on a stock.

The Dow Jones Industrial Average

The direction that the average of the U.S. economies largest 30 stocks heads in has an unprecedented influence on the direction that the remaining stocks on the stock market head in. The DOW is the most widely followed market index and it has a profound influence on the confidence of investors and their view of the markets future. Basically, if the DOW average heads up, then expect the majority of stock prices to also head up. The converse is true if the DOW average heads downwards.

While this is true for the stocks that are not in the DOW index, the stocks that are in the index have their own reasons for the directions their prices head in. To some extend, merely having the DOW average increasing can influence some of the other DOW stocks to follow suit.

Risk Analysis - Why Stock Prices Fluctuate; picture of a stock broker checking his stock charts for information about price fluctuations observed

Leaked misinformation

A company employee (such as an office clerk) sees some documents or over hears management discussing some aspect of the company. This employee then mentions it to a friend who they know invests in stocks, since the employee thought this might be important information. However, as is often the case, this information has no affect on the company's fundamentals and is probably useless information.

This friend now mentions this (probably useless) information to some other people. Thus, this sets up the rumor mill where one investor mentions it to another investor and so on, all of whom act on this information therefore driving the stock's price. After all, these investors don't want to miss out on this hot tip. At some point this information is discredited, but by now the stock's price has probably moved considerably and thus has attracted the attention of other investors. If the price move was upwards, these other investors and indeed speculative traders will use this increased price to sell their own stock positions to lock in a profit from this stock price rally.

Leaked information that is useful will in all likelihood need to be disclosed in an 8-K report, therefore the time frame for the above to occur is very limited and probably will probably have little affect on the stock's price until the information is made public. Of course this assumes that the company is prompt in disclosing its market sensitive information.

Disclosed Information

When a company discloses some information about its operations, it can have a significant effect on the stock's price, especially if the information implies that its current earnings will be affected.

These disclosures can significantly alter the perception that investors have of the stock. If the company discloses that production will be shut down for three weeks due to unforeseen problems, investors may perceive this as a problem with management in not having sufficient foresight to avert the problem, and thus investors may lose confidence in this company's ability to meet its forecast earnings and therefore decide to sell their stockholdings.

Any information that is different from what is expected

can see a stock’s price move dramatically - up or down

The confidence level of stock investors is particularly sensitive to the quarterly earnings announcements. Any disclosed earnings value or other information that does not meet with their expectations can dramatically alter the price of a stock.

Analysts Revision of Earnings Estimates

Investors' confidence in a stock is extremely sensitive to their perceived notion of a stock's future earnings growth potential. Alterations by analysts to their own estimates can have a significant affect on the confidence of investors.

The revision to an estimate is far more significant than the original estimate made by the analyst.

When an analyst alters their original estimate, it signals to investors that something has changed with the company. After all, why did the analyst alter their own estimate?

Downward revisions by analysts tend to have a more dramatic effect on a stock's price than upward revisions do. The price moves are more dramatic if more analysts make a revision in the same direction.

Interest Rate Changes

The Federal Reserve Bank alters interest rates to control consumer spending. For the stock market, this can have a positive effect if the rates are lowered as consumers now have more money to spend, which in turn increases company revenue and hence earnings. Rising interest rates can have the opposite effect.

Investors can react either positively or negatively to an interest rate cut.

One the one hand, rates are generally cut to spur on consumer spending, which signals to investors that spending is down and thus earnings will also likely be down thereby causing a sell down in stock prices.

One the other hand, the increase in consumer spending may relieve investors' concerns that earnings may be down and thus cause a rally in stock prices.

A positive effect interest rate cuts can have on stock investors' confidence is that when rates are cut, the returns from bonds are lowered which can lead to institutional investors rotating capital from bonds into stocks, thus bolstering the price of stocks.

While the effect of rate cuts on stock prices can be either positive or negative, interest rate changes do tend to have a noticeable effect on the stock market.

Industry Group Performance

The confidence of investors is greatly influenced by the strength or weakness of the industry group that the stock belongs too. If one stock in the industry reports stronger than expected earnings, that stock may very well rally.

This can increase the confidence of investors that other stocks in that industry may also report good earnings results, which can cause these other stocks to rally even though they have not yet reported their earnings results. Thus, investors are driving up the prices of these stocks on the anticipation that they will also report good results.

Risk Analysis - Why Stock Prices Fluctuate; picture of stock prices on a phone screen and a newspaper displayed on a tablet screen for risk analysis of stocks for investors

The Financial Press

The financial press has a strong influence on investors. They can readily alter the perception that investors have towards a particular stock or the stock market in general. The financial press can strengthen or totally destroy the confidence that an investor has towards a stock. Simply commenting that a company is poorly managed or that a product is somehow flawed (whether this is justified or not), can send investors running for the exits and driving down the stock's price.

The financial press can also promote a company that has a stock price which has been constantly increasing. This promoting is achieved by writing various articles that highlights any positive features that the company has. This further increases the confidence of investors who see this strong uptrend and want to buy stock, thus increasing the stock's price further, quite often well beyond what is justified. These stocks are commonly referred to as "market darlings" and the relentless financial press coverage can propel the stock price to extremely high levels.

The converse is true if a stock's price is in a downtrend. The influence that the financial press has on investors can destroy their confidence thus driving the stock's price down to ridiculous levels.

To Summarize

The preceding list are the common factors that influence the confidence of stock investors and are generally short lived, ranging from days to weeks or sometimes months. They often have no lasting effect on the company's fundamentals.

The predominate reason stock prices fluctuate so much is due to the imbalance of supply and demand for that stock. When investors are confident, their own buying increases demand for the stock. Conversely, when they are pessimistic, their own selling increases the supply of shares available for sale. Stock investors tend to be very nervous and they over react to their own interpretation of information, which quite often is not fundamentally justified.

The Stock Price Roller-Coaster Ride

The financial market amusement park

Risk Analysis - The Stock Price Roller-Coaster Ride; picture of a roller coater in an amusement park depicting the up downs as seen in the stock markets

Any stock investor who has regularly followed the price behavior of stocks will have come to the conclusion that stock prices fluctuate dramatically, even though their seemed to be nothing that has changed with the stock's fundamentals. This can naturally cause some concern for the stock investor, as they may well be wondering whether it was even worth the effort in conducting a through fundamental evaluation of the stock in the first place.

These seemingly random price fluctuations come about to due supply and demand imbalances for a stock, brought on from the never ending changes in investor confidence and their perception of the stock's future profitability.

These stock price fluctuations are not totally random, but tend to alternate above and below what the company is actually worth. Some stocks will fluctuate more than the market indices and are referred to as high beta stocks, while other stocks fluctuate less than the market and are referred to as low beta stocks. High beta stocks can be highly volatile with huge price swings throughout the year.

There is a continuous tug-of-war that goes on with the stock's price as those investors that are optimistic about the stock are willing to drive up the stock's price, and those investors that are pessimistic about the stock are willing to sell down the stock's price. There have been numerous market theories presented over the years in an attempt to explain this behavior.

This essentially leads to the price chart of a stock resembling a roller-coaster ride. The one thing most profitable companies tend to have in common is that the stock's price spends more time above what its worth, than it does below what its worth. This can lead investors to overly emphasize the rewards and ignore the risks while the stock price increases, but when the stock price falls back to its valuation, investors now tend to overly emphasize the risks and ignore the potential rewards. Both the risks and the rewards are equally important irrespectively whether the stock price is climbing or falling.

The Fundamentally Sound Stock

An example of the price behavior of a typical stock that is fundamentally sound and growing its earnings at a reasonable rate is shown below in Graph 1.

Graph 1. The uphill roller coaster ride of

a fundamentally sound stock

risk analysis; uphill roller coaster ride of a fundamentally sound stock with relative valuation

As shown in Graph 1. above, for a company that is fundamentally sound and growing its earnings at a reasonable rate, the fundamental valuation of the company increases over the years. Thus in 5 years time it is worth more than now and in 10 years time its worth more than in 5 years time. The actual price paid for the stock goes on a real roller-coaster ride, but the important note here is that this roller-coaster is tilted uphill.

Thus the stock price of a company where its valuation is increasing over time, will broadly head higher over the long term. However, over the short to medium-term such a stock can undergo significant price corrections. Basically the higher the stock price tends to be above its valuation, the more dramatic the price declines tend to be.

The Peak Stock Price of a Fundamentally Sound Stock

Now some stock investors will be commenting that they bought a stock 5 years ago for $50 and for the last 4 years it has been trading for only $20 to $25. The stock's price just will not go back to $50. This all too common phenomenon is illustrated below in figure 2, assuming that the company is fundamentally sound and growing its earnings at a reasonable rate.

Graph 2. The peak price of a fundamentally sound stock

risk analysis; he peak price of a fundamentally sound stock that then declines later

Referring to figure 2. above, investors who bought this stock near its peak will have to wait a long time (upwards of a decade or more) for the stock price to reach the peak price level before the stock price crashed.

This is a common feature of high growth stocks and speculative stocks where investors have paid prices that were way above what the stock was worth. Usually these investors bought at these high overvalued prices not because the company's earnings were significantly growing, but because the stock price was significantly growing. This is an all too common trait of beginner and novice investors who have no real understanding of the stock market.

Risk Analysis - The Stock Price Roller-Coaster Ride; animated picture of a lady showing stock charts to three investors while sitting in an office

Stock investors will often sell such a stock as they become impatient waiting for the stock price to return to its former peak While this is justified for a stock that is not fundamentally sound, these investors' also sell stocks that are fundamentally sound (as illustrated in figure 2).

Fundamentally sound stocks that have had a significant price correction are favorite candidates for the financial press. They will typically highlight any negative features of the company, which in turn further suppresses the already subdued confidence of investors.

The net result is that these former high share price gain stocks will trade closer to what they are worth and will usually do this for quite some time. At some stage in the future (usually distant future), the confidence investors have in this stock may pick up again and thus the stock may enjoy a resurgence in its share price, once again driving its PE ratio way above what is justified.

For the investor that is still holding this stock, as long as the stock remains fundamentally sound and its earnings continue growth at a reasonable rate, then at some point in the future its valuation will reach its former peak stock price level.

A distinction needs to be made between a stock with its price heading downwards and a stock with its valuation heading downwards. All stocks go through cycles of uptrends and downtrends.

This is the normal ebb and flow of the stock market. So a stock were its valuation is increasing over time will have periods were the stock price is heading upwards and periods were its stock price is heading downwards.

The Stock that is not Fundamentally Sound

The discussion has so far been on a fundamentally sound stock, but what about a stock that is not fundamentally sound. What if its financials are deteriorating at a significant rate that even has the accountants worried?

Basically, the company's valuation now heads downwards, which is to be expected. If a company keeps losing money, it is depleting its working capital and its net assets, all of which is obviously not good news. The stock price for such a stock still spends a lot of its time above what it is worth and has the same fluctuating price behavior as discussed for the fundamentally sound stock, except that the general direction the stock's price is now heading downwards. This stock will still have significant price rallies, which may give the illusion that the stock price may even be heading upwards. This is illustrated in below figure 3.

Graph 3. The downhill roller coaster ride of a stock

that is not fundamentally sound

risk analysis - downhill roller coaster ride of a stock that is not fundamentally sound

Unlike the fundamentally sound stock were the stock price will eventually recover, the real problem for investors that hold stocks which are fundamentally deteriorating is that the price will never recover as long as the stock's valuation continues to head downwards.

This is to highlight that value investing (that is buying below what the stock is worth) in these fundamentally deteriorating stocks, only leads to the stock's valuation to drop below what the stock investor originally paid. Thus, what started off as the purchase price being below its valuation, ultimately the stock's valuation ends up being below the purchase price given enough time. This comes about because the valuation line is declining over time.

Risk Analysis - picture of risk management wording printed on a black keyboard with keys in large scale red font on computer

Risk Analysis of Stocks

Investors are notorious for focusing on the rewards, but ignore the risks

The absolute maximum that the stock investor can lose on an investment is the price paid for the stock; however the maximum profit the stock investor can make is virtually unlimited, even though there are some realistic limits. A stock can only lose 100% and no more, but it can make 500%, 1000% and more over the long-term. Thus the basic premise for investing is to make more money from the stocks that succeed, than lose from the stocks that fail.

Basically, if a company's earnings continues to increase, then the company's fundamental valuation continues to increase and the stock price will fluctuate about this valuation line in an upwards direction. While this is what is expected to happen from a fundamentally sound company, the future is by no means a guaranteed certainty. Some of these companies will experience financial difficulties at some point in the future, with some of these companies even heading into bankruptcy.

Thus the stock investor needs to make allowances for these possible outcomes and build their portfolios accordingly. Diversifying is a means of spreading the risk across several different stocks since if only one stock were bought and it ends up bankrupt - then the entire portfolio is lost.

The risk-reward analysis is the first analysis that is performed and forms the basis for risk analysis. This is simply a ratio that is used to determine whether the profitability of an investment is worth the risk taken. The two components of risk-reward are discussed in detail.

Reward Analysis

The fundamental analysis conducted on a stock provides the stock investor with the likely earnings for the company in the coming years (usually one or two years). These earnings can be extrapolated further into the future. Generally, five years of future earnings estimates is sufficient.

The PEG ratio valuation provides a quick and easy method of arriving at a future fair value for the company. This is a popular approach used for growth stocks. If a stock has a projected earnings growth rate of 20% per year, then a fair value for the stock is a PE ratio of 20.

But stocks during bull markets will commonly trade at multiples that are several times fair value, in fact three to five times fair value is quite common for the market darlings. While the fair value PE ratio would be 20, they can easily trade at PEs of 60 or 100.

To determine the reward in five years time, two values are used - the expected reward and the maximum reward.

The expected and maximium reward:

  • The realistic expected reward is calculated by using fair value PE ratio in 5 years time.
  • The maximum expected reward is calculated buy using an optimistic multiple; we will use three times fair value PE ratio.

The main reason for using two values for the reward is that risk analysis involves assessing a range of probable outcomes.

In order to determine the stock price in five years time, the future earnings in five years time needs to be determined first. The following example assumes an earnings growth rate of 20% per year as shown below in Table 1.

Table 1. Expected PE and Price in 5 years (with

earnings growth of 20% per year)

Year Earnings Fair Value PE Fair Value Price Maximum Expected PE Maximum Expected Price
2018 1.00 20 $20
2019 1.20 20 $24
2020 1.44 20 $29
2021 1.73 20 $35
2022 2.07 20 $42
2023 2.50 20 $50 60 $150

From Table 1. the fair value PE is 20 which gives a fair stock price of $50 in five years time. The realistic expected reward is the fair stock price less the current stock price. Thus, if the current stock price was $20 (which is the current fair value), then the realistic expected reward will be $30 (which is $50 less $20).

Similarly, the maximum expected reward (assuming three times fair value) will be $130 (which is $150 less $20)

Risk Analysis - picture of a risk reward sign on a stock chart with the graph showing an increasing trend upwards to signify profits

Risk Analysis

The next component that needs to be determined is the risk. While it is comforting to assume that a stock will continue to grow its earnings as anticipated, the reality is that there is a good change this will not happen as expected and as such the stock investor needs to know how much risk they are taken on.

Basically there are two types of risk the stock investor faces. The first risk is that the company does not grow its earnings as expected and may very well run into financial difficulties. This risk is covered in this section. The other risk is that the stock market in general undergoes a major correction and is covered in the next section.

The most conservative and simplest approach for the risk analysis is to assume the maximum risk, which occurs if the company heads into bankruptcy and thus the entire initial investment is lost.

While a more accurate risk analysis can be performed by determining the probability of a company becoming insolvent using the Z-score, for the high risk growth stocks (especially small and micro-cap stocks) it is easier to simply use the price paid for the maximum risk value.

Thus for the example from Table 1. the maximum risk is simply what was paid for the stock which is $20

For the lower risk stocks (such as the stocks in S&P 500 index), the maximum risk is generally overly conservative. Therefore a realistic expected risk is also determined and the Z-score calculated for bankruptcy risk.

The tangible net assets are a convenient figure to use for the determining the realistic expected risk. While it is a little conservative, the basis for using tangible net assets is that companies in the S&P 500 index are generally all profitable companies and when they have a bad run financially, it's usually that they are struggling with consistently increasing their earnings. For example, a company may have earnings one year of $1.00, the next year's earnings of -$0.20 and the year after that, report earnings of $0.80. While this company is still profitable, stock investors are probably not going to be confident in bidding up the stock price and there is a good chance they will discount any future earnings potential. Thus, this only leaves the tangible net assets value of the company if the earnings are excluded.

It is generally better to use the tangible net assets value rather than book value so that the company's intangible assets and goodwill are excluded. For example, the company has tangible net assets of $100,000,000 and 10,000,000 shares outstanding, which gives a tangible book value of $10 per share. The realistic expected risk is the stock price paid less the tangible book value.

Thus the realistic expected risk is $10 (which is the $20 stock price paid less $10 in tangible book value).

Risk-Reward Ratio

The risk-reward ratio is simply the ratio of how much money can be made if everything goes according to plan and how much money is lost if everything goes wrong.

Investors should consider the risk reward

for all their potential investments

Generally, the higher the chance of an investment failing, then the higher the minimum accepted risk-reward ratio should be. For large blue-chips which have a low probability of heading into bankruptcy, a risk-reward ratio of 1.5 is generally acceptable. Whereas, a small-cap high growth stock which has a higher probability of heading into bankruptcy, a risk-reward ratio of 3 or even 5 would be an acceptable minimum.

The risk-reward can now be determined using the values obtained from the previous sections.

The first risk-reward ratio is calculated from the realistic expected reward divided by the realistic expected risk.

Realistic risk-reward = 30 / 10 = 3

This means that the investor can make 3 times more money if the company's earnings performed well than what the investor would lose if company's earnings performed poorly.

The same ratio is calculated again, but this time using the maximum reward and maximum risk values. This gives the extremes if the stock performs really well or really badly.

Maximum risk-reward = 130 / 20 = 7.5

This means that in five years time, the stock investor could potentially make 7.5 times more money than they risked on their initial investment. Of course the stock price may never hit $150 a share and the stock may not end up bankrupt even if it did run into financial difficulties, but the purpose of this calculation is to determine the impact on an investor's portfolio if these extremes were to eventuate.

So paying $20 a share makes this stock an attractive investment with a realistic risk-reward ratio of 3. But what if the investor were to pay say $40 a share for this example 20% growth stock?

Re-calculating the risk-reward figures gives:

Realistic risk-reward = 10 / 30 = 0.33

Maximum expected risk-reward = 110 / 40 = 2.75

Thus the risk-reward ratio is quite sensitive to how much an investor pays for their stocks. The realistic risk-reward is now unacceptable as the investor now stands to lose more money than what they will likely make. Basically there are only two ways an investor can make money paying $40 a share from this example stock:

Make money paying $40 a share

  1. The company actually succeeds in growing its earnings from $1 to 2.50 in five year's time.
  2. If its earnings only reach $1.50, then the investor is reliant on a market that is willing to pay a high PE multiple that is way above what its earnings growth is worth.

Example Stock

The risk analysis discussed above can be applied to a growth stock such as Five Below, Inc. which is a specialty retailer Mid-cap stock. Five Below has produced strong revenue and earnings growth over the last five years as shown below in Table 2.

Table 2. FIVE - Revenue & Earnings

Year Revenue Earnings Earnings Increase
2012-01 0.30.30
2013-01 0.40.37 23%
2014-01 0.50.58 57%
2015-01 0.70.88 52%
2016-01 0.81.06 20%
2017-01 1.01.31 24%

The average annual earnings growth from Table 2. above for Five Below is 35%. The current stock price is around $66 which gives a PE of 50 based on 2017-01 earnings of $1.31.

However, investors are forward looking and prefer to use the current full year earnings estimate. The broker consensus earnings estimate for 2018-01 is $1.80 which gives a PE of 37. The Tangible Book value is $6.

With the earnings growing at 35% per year, in five years time the earnings would reach $5.87 (in 2022-01). With a PE of 37 gives a stock price of $217.

The Realistic risk-reward can be determined with a current stock price of $66 and a future stock price of $217 with a tangible book value of $6.

Realistic risk-reward = (217-66) / (66-6) = 2.5

The Maximum risk-reward can be determined by assuming that investors would pay a premium over its fair value in five years time. If we assumed the market might pay double thus giving a future smock price of $434 then the Maximum risk-reward can be calculated assuming the full stock price of $66 is at risk.

Maximum risk-reward = (434-66) / 66 = 5.6

Realistically the investor stands to make around 2.5 times more money in five years than what was risked. The maximum reward is an optimistic view but does eventuate - mainly in strong bull markets.


The Risk-reward analysis is a means of evaluating the monetary risk associated with a proposed stock investment. Beginner investors can get caught up in focusing exclusively on either the risk or the reward - both are equally important and not just one or the other.

Analysis of Stock Market Cycles

The long-term upward bull market direction is occasionally interrupted by a downward bear market

Risk Analysis - Analysis of Stock Market Cycles; picture of a black bear market and a black bull market cycles animals shown on two road signs with a yellow background

Beginner stock investors typically expect immediate gains and continuous gains; however the stock market trades in cycles. The two market cycles are, the Bull Market cycle where stock prices are broadly increasing year after year and the Bear Market cycle where stock prices are broadly declining for a year or so

These market cycles are essentially brought on due to the change in confidence investors have in the ability of companies to growth their earnings and this earnings growth is largely dependant on the business cycle. There is a strong correlation with companies increasing their quarterly earnings and the increase in stock prices.

The correlation between Company Profits and the performance of the stock market is illustrated in the following two charts.

The first chart shows the Company Profits (using data from the U.S. Department of Commerce) plotted with the Federal Reserve Bank of St. Lousis FRED (Federal Reserve Economic Data) system.

The second chart shows the S&P 500 stock market plotted since 2003. Both charts show the 2008 recession (also known as the 2008 financial crisis) highlighted with the light grey shaded box. During a recession company profits generally fall and so do stock prices.

Chart 1. Corporate Profits

Risk Analysis - Quarterly Profits after tax Chart with data from FRED economic federal reserve

Chart 2. S&P 500

Risk Analysis - Chart for SP500 stock market index showing the 2008 financial crisis and bull bear market cycles experienced by investors

When companies are growing their earnings and investors are confident that these companies can continue this growth, then investors will generally be willing to pay for this future earnings growth. This can have a positive effect on investors increasing the forecast PE multiples along with the increase in earnings. The forecast PE multiples are also influenced by the inflationary environment. The net result is that the prices of stocks increase and this cycle is known as a bull market.

However, if these earnings growth rates decline or worse, become negative, then investors become pessimistic and are no longer willing to pay for any potential earnings growth. This can have a negative effect with investors decreasing the forecast PE multiples along with the decrease in earnings. The net result is that the prices of stocks decline and this cycle is known as a bear market.

The ability of companies to grow their earnings is very sensitive the state of the U.S. economy as measured by the Gross Domestic Product. In a strong buoyant economy, earnings growth is relatively easy. However, when the economy is struggling, then earnings typically decline and growth rates often become negative. The investors will remain pessimistic until they regain their confidence in the ability of companies to grow earnings and this will generally not occur until the economy itself shows signs of recovering.

Risk Analysis - Analysis of Stock Market Cycles; picture of a business section of the newspaper with a market rebounds article written for stock investors about the market correction

This leads to two issues for stock investors in managing their portfolio.

The first one is that even if a company manages to continue with its earnings growth, if a bear market comes along, investors will still drive down the forecast PE multiple, especially if the forecast PE is above the stock's earnings growth rate. The reduction in the stock's price can be quite dramatic even though the company is still growing its earnings. As mentioned above, investors will not be willing to raise the forecast PE multiple until they are confident that the economy itself will support any future earnings growth.

The second issue is even worse if a bear market emerges. The earnings growth rates of most companies become negative in a recessive economic environment, which leads investors to discount any future earnings growth potential. Thus, the only value investors are placing on companies is their net assets and the bottom of significant bear market declines will see many companies trading somewhere around their net assets value.

Stock investors need to allow for the emergence of a bear market and analyze their stock holdings for the potential effect that the bear market will have on their portfolio.

It is prudent for the stock investor to perform this analysis every time they take on a new position or add to an existing position.

The full extent of a bear market on the earnings of companies is never known until the bear market has actually ended. Some bear markets are only minor while others can lead to a major financial crisis. Thus, the stock investor needs to assume the worst case scenario that the bear market will be significant, even though this may not eventuate. The motto is that it is better to be safe than sorry. This is the basis for some of the famous value investors such as Benjamin Graham and Warren Buffett.

Stock price sell down in a bear market:

  • For companies that are financially sound, the net assets per share provides a good guide as to where the stock price will probably bottom out at.
  • Larger companies that are financially under pressure, the tangible book value would be a wiser chose as this excludes the intangible assets and goodwill. In major bear markets, investors may be so pessimistic that they even discount any intangibles.
  • Companies that are fundamentally unsound (especially smaller companies), it is safer to use half of the tangible book value, as major bear markets can easily drive the stock price of an unprofitable company down to half of its tangible book value.

Using these values for determining how far a stocks price might sell down in a bear market provides the investor with a quantitative figure to use in assessing the potential impact on their portfolio.

Risk Analysis - Analysis of Stock Market Cycles; picture of a road sign with a green background showing white writing that says market rally cycles just ahead

As an example, a fundamentally sound stock trading at $20 with a tangible book value of $10 per share and growing earnings at 20% per year, may very well sell down to around $10 in a major bear market. This is only a guide, but does indicate how significant the impact may be on the investor's portfolio. Once the bear market is finished and earnings growth recovers, then both the earnings grow and the forecast PE multiple will recover, thus the stock price decline is only short lived. While this will typically take a few years, to the impatient investor this may seem like a life time.

As another example, a small-cap stock that is fundamentally unsound that has not made a profit in the last 5 years and is trading at $10 with a tangible book value of $2. It is not uncommon for such a stock to fall to $1 in a major bear market (which is half of the tangible book value). Needless to say, that is a 90% decline.

The stock investor can readily determine the maximum likely impact of a major bear market on their portfolio by simply determining the stock prices and calculating what the portfolios value would be based on the number of shares held for each stock.

It should be noted that a lot of stock investors (especially beginners) sell their stockholdings near the bottom of bear markets on fear that their portfolio will never recover, thus booking a large loss. Professional stock investors reduce their stockholdings earlier in the bear market and actually start re-purchasing their stocks as the stock prices head towards their tangible book value for the fundamentally sound stocks.

Portfolio Diversification

Risk Analysis - Portfolio Diversification; picture of a clock with a white background with red writing on it saying its time to diversify your investments

Don't put all your eggs in one basket

The next stage in risk analysis is the management of risk. This allows the stock investor to control the amount of risk their portfolio is exposed too.

Diversification Basics

Diversification simply means not too put all your eggs into one basket. For the stock market, it is prudent for the investor to spread their selection of stocks across varies industry groups that are not related.

The share prices of stocks within a particular industry group tend to move in a similar fashion. If a particular industry group rallies, then most stocks within that group will tend to rally, whether they deserve too or not. Conversely, if the industry group declines, then most stocks in that group will also tend to decline.

An example of an industry that is currently moving as a group is within the banking industry - especially American based banks - as shown below in Table 1.

Table 1. Banking Stocks

Risk analysis - Portfolio Diversification with Table showing banking stocks and stock price performance over the last year

As the above table shows, most of these 10 large banks have gained around 30% to 40% over the last year. This fine is when a single industry performs well (such as the banks have over the last year) but if the industry performs poorly then the entire portfolio performs poorly.

However, different unrelated industry groups will tend to rise and fall independently of each other, especially if the industry groups are in different sectors. Thus, one industry group might rally while another industry group might be declining.

By investors spreading their stocks across different unrelated industries, they can obtain a more consistent return from their stock portfolio. The fall of one industry group can be offset by the rise in another group. This does not mean that the value of the portfolio won't decrease; it simply means that the fluctuations in the portfolio's value are generally not as extreme.

It should be noted that there is no requirement for a stock investor to diversify, but it is a tried and proven method of managing and balancing the risks associated with stock investing for the typical investor. However, there are always exceptions.

Some stock investors may be intimately familiar with a particular industry as a consequence of their employment within that industry. Such an investor might be a research scientist who works in the development department of a drug company and thus has significant inside knowledge of that industry. This investor will be fully aware of new and proposed drugs being developed within the drug industry, even if it's by a competitor. Hence this investor being such an expert in their industry, may very well choose to specialize in that industry rather than diversify their investing into other industries that this investor is not an expect in.

Selecting the Industry Groups

For most stock investors, having a diversified portfolio of stocks will lower the volatility in their portfolio's returns. Incorporating about 10 unrelated industries will do a good job of lowering the volatility. If the investor is looking to hold say 20 stocks in their portfolio, then they can include two stocks from each industry group or alternatively select a stock from 20 different industry groups.

Risk Analysis - Portfolio Diversification; picture of an investor pointing at a sign with a black background with various industries written on it in white font

There is no set rule as to what industry groups to select and to a large extent is dependant on each individual investors' preferences and industry knowledge. Certainly it makes good sense for an investor to select the industries they have a better understanding off, or at least industries they have a personal interest in.

For an example, an investor may have a keen interest in computerized technology even though they are not employed in that industry. Such as investor will no doubt have an industry knowledge advantage over another investor who has absolutely no interest in computerized technology? It's generally a good idea to take advantage of any knowledge an investor may have.

This same investor may also be good at mathematics, thus such an investor will find the financial industries easier to relate too and understand than an investor that has poor mathematical skills.

This industry knowledge is the approach the famous investor - Peter Lynch used extensively in constructing his portfolios. Even Warren Buffett will only invest in industries he understands.

Another popular strategy used by stock investors in selecting which industry groups to considerer is referred to as Top-Down sector analysis. The basis for this technique is to first determine the better performing sectors and then select the best performing industry groups from these sectors.

There are always some industries that are performing strongly while other industries are performing poorly. The idea with this approach is to select stocks from the strongest performing industries. The performance can be based on two different criteria as follows:

Industry performance criteria:

  1. The company revenue generated as a percentage of the industries total revenue. This is the fundamental analysis approach.
  2. The stock price outperforming the industry index. This is the technical analysis approach and the out-performance is referred to as relative strength.

It should be noted that these two approaches will often give different industry leaders. The revenue leader is most likely the largest company in that industry, whereas the strongest stock price increase might well be from a smaller competing company.

Investors should however be aware that the performance of individual industry groups tends to cycle. An industry that is a strong performer one year may be lackluster the following year.

Top-Down analysis does provide the stock investor with a short list of industries that are performing well. If a proposed stock is in such an industry, a lot of investors feel more comfortable buying a stock if the industry group it belongs to is also performing well.

Yet another way to select the industry groups is to simply obtain a short list of stocks from a stock screening application (which most online stock brokers have). Before conducting a thorough fundamental analysis on the stocks, first determine which industry group the stocks belong too. If there are too many stocks for a particular industry group, simply select the better stocks (such as those with higher growth rates) from each industry group and then conduct a thorough fundamental analysis on these stocks.

Thus using a process of elimination, the investor can select the best one or two stocks from a variety of industry groups.

Stock Position Sizing

Working out how many shares to buy

Risk Analysis - Stock Position Sizing; picture of an investor pointing at a sign on a glass see through panel with the writing saying shares to buy now

The first consideration is to determine the amount of capital to allocate to an investment portfolio as this will determine the relative brokerage costs.

The next consideration is to determine how many shares to hold for each stock in a portfolio.

Initial Stock Position Size

The stock investor now needs to determine the dollar amount to allocate to each stock and the simplest method is to allocate the same dollar amount to each stock in the portfolio.

Using this fixed dollar amount method, the investor simply divide's the proposed investment capital by the number stocks to be held in the portfolio. For example, an investor decides to invest $10,000 to start with and plans on holding 10 stocks, thus each purchase will be for $1,000 worth of stock.

While this is the usual method beginner investors' use, it is not normally the best method from a risk management point of view. This is because the risk level usually differs between the stocks selected for the portfolio. A higher risk stock may potentially lose more than a lower risk stock in the event of a market decline. For example, $1000 of a higher risk stock might lose 50% and a $1000 of a lower risk stock may only lose 10%, which makes the portfolio unbalanced as one stock alone may cause considerable damage to the portfolio's value.

Buying an equal dollar amount for each stock can

produce a portfolio that is unbalanced for risk

Professional stock investors incorporate the expected risk that was used to calculate the risk-reward ratio. The expected risk is used to calculate the dollar value of stock to purchase. Using the above example, the investor might only buy $700 of the higher risk stock and buy $1300 of the lower risk stock.

This method has the advantage of balancing the dollar risk of each stock held in the portfolio, but it does have the disadvantage that it is more difficult for beginner investors to implement. The main reason for this is that the dollar amount per stock is variable, so the investor cannot simply divide the capital by the number of stocks. The dollar amount of stock to buy is calculated as follows:

Calculate the dollar amount of stock to buy:

  1. First the stock investor determines the dollar amount they will risk per stock. For example, $1,000 per stock.
  2. Next, which expected risk value to use is determined. For a fundamentally sound stock, the realistic expected risk value is appropriate to use. However, for a fundamentally unsound stock (especially if there is a high risk of bankruptcy), it is better to use the maximum expected risk value (which is simply the stock's purchase price).

The calculations are as follows.

Number of shares to buy  =  dollar amount risked / expected risk

Dollar amount of stock  =  stock price x number of shares

Example 1. A fundamentally sound $20 stock risking $1,000 with a realistic expected risk of $10 per share.

Number of shares = $1,000 / $10 = 100 shares

Dollar amount of stock = $20 x 100 = $2,000 worth of stock

Example 2. A fundamentally unsound $20 stock risking $1,000 with a maximum expected risk of $20 per share.

Number of shares = $1,000 / $20 = 50 shares

Dollar amount of stock = $20 x 50 = $1,000 worth of stock

Using the above examples, the investor would allocate twice as much capital to the lower risk stock than what they would to the higher risk stock. The stock investor's portfolio risk is now balanced as both of these stocks could be expected to lose $1,000 in a severe bear market.

Variable Stock Position Size

Once the initial position is taken in a stock, it is normal for beginner stock investors to hold the full quantity of initial shares purchased. When and if they decide to sell a stock, they will normally sell the entire quantity of shares in one transaction.

Risk Analysis - Stock Position Sizing; picture of an investor using a calculator to check the earnings charts for a stock using a tablet for assistance

Professional stock investors will normally adjust the number of shares held for each stock depending on how overvalued or undervalued the stock is based on a valuation technique. That is not to say that they are necessarily speculative trading, but they are constantly re-evaluating and adjusting their portfolio.

Typically the money received from selling some of the overvalued shares is used to buy more shares in a stock that is undervalued. For example, an investor might sell 20% of their shares in a stock when it is overvalued by 50% and they might buy an additional 10% of shares in a stock that is trading at 80% of its valuation. This of course assumes that the stock is still fundamentally attractive.

Apart from the risk balancing aspect, this tactic also allows stock investors to maximize their returns. The basic premise is that the more overvalued a stock is, then the less exposed the stock investor wants to be in the advent that a bear market should emerge. This is achieved by owning less stock as the stock becomes increasingly overvalued.

This has two benefits, firstly the stock investor is continuously locking in profits as the stock keeps on becoming increasingly overvalued and secondly, with such an overvalued stock a bear market will see its stock price tumble significantly.

Selling stock at those overvalued high prices increases the profits added to the portfolio. Owning less stock when the markets turn reduces the damage that's done to the portfolio. The famous investor - John Templeton made good use of this tactic.

The investor should note that the reference to overvalued or undervalued refers to the stock's price relative to the company's valuation and not to the stock price in isolation. Thus, a stock may have increased in share price by 100%, but it is still fairly valued (not overvalued) since its earnings also increased by 100%. A lot of stock investors use the stock's price in isolation and may consider a 100% increase to be overvalued - their basis is that the stock price has increased significantly and their fear is that the stock price may collapse. This is an emotional response that tends to plaque a lot of stock investors.

The stock investor might comment on the additional brokerage charges involved with rebalancing a portfolio. In should be stressed that the main point of investing is to maximize returns and minimize the risk and volatility of those returns. The additional brokerage is merely a minor expense in maintaining a portfolio that is risk managed.

Stock Risk Control Tactics

Risk Analysis - Stock Risk Control Tactics; picture of white cubic blocks with letters to spell out the words profit and loss and risk in white large scale font

Actively managing your portfolio

Stock investors have options as to how they can manage the risks associated with investing in the stock market. The primary risk an investor faces is that a stock's price will actually decline rather than increase as originally anticipated.

An investor will buy a stock and if its price increases all is fine. However, if the stock's price declines, the investor will typically hold onto the stock until its price has declined to such a significant extent that the investor can no longer emotionally tolerate the psychological pain of the capital loss endured.

This is a fact of life with stock investing and professional stock investors have a variety of tactics they employ to manage and control these risks.

One such tactic is generally referred to as the Stop-loss and Re-enter tactic. While there are numerous versions of this tactic (some of which are quite advanced), there is a simple version that all stock investors can use.

The tactic requires the stock investor to actively follow the stock's price, so it's not a passive investing tactic. The basic principle is to actually sell the stock if its price declines by a fixed percentage (say 10%) below its purchase price (This is referred to as a Stop-loss which is commonly used with investors trading). If the stock's price later regains strength and trades back at the original purchase price, the stock can be bought again (this is referred to as Re-enter) as long as the original fundamental criteria is still applicable.

The reason the original criteria is important is that if the stock was selected as say a growth stock which was then sold, the stock still needs to be a growth stock later on when re-buying the stock. If this stock were no longer considered a growth stock, then it would not be re-purchased. The investor needs to consider whether they would buy the stock the second time based on its fundamentals if they had not bought it the first time.

An example of the Re-entry technique is demonstrated below in Chart 1. with On Assignment, Inc.

Chart 1. Stock Re-entry

Stock Risk Control Tactics shown on monthly stock Chart for investors to control risk in their portfolio

As the above chart shows, stock purchased in On Assignment, Inc. at $36 with a 10% stop was stopped out at $32.50. However, the stock was re-purchased at $36 after being stopped out.

All tactics have advantages and disadvantages.

The advantage of the Stop-loss and Re-enter tactic is that it takes the investor out of a stock that is just trading in the wrong direction after it was bought. It happens and for investors that buy overvalued stocks this tactic can save them a lot of money if the stock's price collapses. If the stock price turns back up as it did with On Assignment, Inc. in Chart 1. above, the investor can simply re-purchase the stock.

Risk Analysis - Stock Risk Control Tactics; picture of an investor assisting a man who is checking risk on a computer with stock data and charts shown on the screen

The disadvantage is that sometimes a stock's price actually trades sideways in a fluctuating manner causing numerous exits and re-entries. This means that after buying the stock, its price drops below the stop and is sold, the stock then trades back to its original purchase price and is re-purchased, the stock then trades back down to its stop again and thus sold only to trade back up again to its original purchase price where it is re-purchased again. This process can repeat numerous times and is referred to as Whip-sawing. It is annoying and frustrating, but fortunately the whip-sawing is usually limited to a few re-entries as most stocks do not trade sideways for any extend period of time. Typically the stock will either continue trading up or trades down.

Another consideration is the tax treatment with selling stocks at their stop-loss level. For tax purposes, these accumulated capital losses are used to offset any capital gains made from stock that is sold at a profit.

The merits of utilizing a risk control tactic such as the stop-loss and re-enter tactic is directly related to the risk profile of the investing strategy used.

For a very high risk strategy such as buying overvalued small-cap growth stocks, this tactic significantly reduces the risks as such a stock purchase will see its stock price tumble towards its tangible book value should investors for whatever reason refuse to pay for its future earnings. For example, an investor pays $100 for a stock worth $50 based on its earnings growth. Should the market lose confidence in the stock's earnings potential due to say poor earnings results and thus refuse to pay for any future earnings, such a stock will most likely be sold down to its tangible book value as this is now the only value left in the company. Now if its tangible book value were $10, the investor would bought at $100 stands to lose a lot of money.

For a relatively low risk strategy such as value investing involving buying fundamentally sound companies near their tangible book value, the stop-loss and re-enter tactic can be altered to increase its profitability by reducing the re-entry price level. The stop-loss as stated above was set at 10% below the purchase price. The re-enter price for lower risk strategies can be set at say 5% below the original purchase price. For example, an investor buys a fundamentally sound stock at it tangible book value of say $10 and the price trades down to $9 and is sold. The stock then trades back up to $9.50 and is re-purchased. This allows the investor to re-buy the stock for less than it was originally bought for. The new stop-loss is now set at 10% below the re-entry price of $9.50 which is $8.55. Should the stock trade below its stop and thus sold again, it would be bought back at 5% below the $9.50 entry price which is $8.97.

This approach to the stop-loss and re-enter tactic has the disadvantage that the investor is effectively chasing the stock's price should it continue to decline below its tangible book value. However, this is partly offset by the investor re-buying the stock at lower prices each time the stock is re-bought thus increasing the capital gain when the stock's price decline actually hits its bottom.

With any tactic designed to manage risk, there is a tradeoff between the risk it is designed to control and the unwanted whip-sawing that can occur. The issue to consider with the Stop-loss and Re-enter tactic is that investors can incur numerous re-entries which accumulate the losses they incur. This is fine during bull markets as stock prices typically resume their upward trend, but in bearish markets there are typically few stocks that will trend upwards leaving the investor with numerous small losses. It should be stressed that if the investor had not sold at their stop during a bearish market, then the capital losses would be even greater, especially for overvalued stocks.

Generally, the higher risk strategies benefit the most for the Stop-loss and Re-enter tactic, especially during bearish markets. The tactic discussed in this article is a basic version that investors can use to manage their risks. The actual percentage figure is somewhat arbitrary and is best determined by examining the historical pricing behavior of a stock by analyzing its price chart. For most stocks the 10% figure gives the stock's price some room to move before triggering its stop. If the figure is too small such as 1%, then the investor will be frequently exiting and re-entering (although the losses will be very small, but the increased activity will be more suitable to stock traders such as position traders).

The decision as whether to incorporate this type of risk control is at the discretion of the investor.

Stock investors who use relatively low risk strategies and prefer to be passive investors (meaning they prefer not to actively track stock prices) tend not to use this form of risk control. Stock investors who engage in high risk strategies generally prefer to incorporate Stop-loss and Re-enter tactics in order to protect their portfolio.

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