Tuesday, September 29, 2009

Risk, and stock insurance

President Reagan being sworn in for second ter...Reagan being sworn in as President (1985) Image via Wikipedia


Just imagine this... You don't bring knives to a gunfight, do you? Or race your family wagon at the Indy 500?

A lot of people have some deep core values that take a LOT of effort to reprogram. And until you update them to reflect current trends and needs, you will have a very hard time succeeding.

Your mind is a tool, YOUR tool, except your mind can be updated... If you want to. And your mind is the most important investment tool of all. And you would want the best available, right?

When it comes to investment, most people can't see beyond the word RISK. So let's update your mind about what really is risk.


== Risk, Risk Aversion, and Risk Management ==

A lot of people refuse to invest in stock market because they believe stock market is risky.

When I talked to my uncle the other day about learning stock options, the first words out of his mouth were "Options are risky."  Same when I talk to my friend. In fact, he got a friend to tell me the same thing.

So what really is risk? Risk is generaly defined as "quantifiable possibility of incurring loss". For example, if you flip a coin, and bet on one side, your risk is 50%. It's also known as "even odds" as your chances of winning is same as losing. If you play money at a casino, you can guarantee that your risk will be > 50% (i.e. the odds are against you winning), as the casino have to make their money SOMEWHERE. Slots are the worst, as your risk is somewhere between 52 to 65%. Table games are closer to even, but NOT even.

So what is risk management? There are "gambling systems" out there, like card counting, poker strategies, and so on that claims to put the odds in your favor. I can't comment about all the systems, as I have not tried them, but usually the casinos have done all the analysis and while these systems, when implemented correctly, can reduce your risk, most can't even reduce it to "even odds" (i.e. 50% risk), but I am off topic here. The point is, risk can be managed in various ways, and while not eliminated (which is impossible, as there are no sure bets in life) using some sort of a system can certain IMPROVE your odds and reduce your risk.

Yet most people, when confronted with risk, their initial reaction is "it's too risky for me".  And they refuse to even consider it. It's known as "risk aversion". They want to play it safe. That is the reaction of the non-rich, something you need to UNLEARN.

As the old saying goes, "no pain, no gain". That's usually referring to exercise and weight loss, but it applies to investment as well.  Another saying is "winning is not afraid to lose". Or as Rich Dad (tm) puts it, "If you can't afford to lose, then you have already lost".

Logically, there is no such thing as a "100% safe investment". Sure your money in bank CDs are 100% insured by the FDIC and so on, but are you actually earning enough interest to cover inflation? If you don't, then you are losing money already. Your money is ALWAYS AT RISK. Even those you thought were 100% safe is probably LOSING VALUE, and therefore, at risk. The larger the risk, the larger the potential reward (or else, you're doing something wrong).

Investors are NOT gamblers. Investors use various tools and controls to manage and reduce risk, tools such as investment systems, options, spreads, collars, and so on, while seeking the maximum return. There are ten levels of investor controls that an investor can exercise to manage and even reduce their risk when investing. (For details, please check Rich Dad's guide to Investing.) Risks can be MANAGED, thus, risk should not be the excuse to do nothing.

So how can risk be managed? By understanding what is involved in the risk, and seek to control the factors. (As stated before, consult the 10 levels of investor controls to manage your risk while investing.)

Why can risk be managed? It is easier to illustrate this with an example: Is driving a car dangerous? There are drunk drivers out there, your car's brakes can fail, the road can be slippery, there are crazy pedestrians out there, road rage drivers... I can go on and on about the risks of driving. HUNDREDS of people die on the road every day. But the fact is, everybody drives, because of several things: 1) we all have to study some basic rules to be even allowed on the road. Some minimum competence in driving is assumed (that's why driving without a license is such a big deal). 2) you can buy insurance. Usually the insurance is for liability, i.e. if you screw up and hit someone else, but you can also buy it for collision, i.e. for your own vehicle, even if you're at fault, and medical (for your own and other medical bills) and other risks, and 3) the cars nowadays are much safer than the ones before, with airbags, stablility control, anti-lock brakes, and so on. 4) you maintain it properly to make sure it has good tires, good brakes, and so on.

However, when it comes to investing, there is no such thing as a minimum level of competence. Any MORON (my apologies to those who are, uh... intellectually challenged) with money can put it in the market without knowing ANYTHING about the market. There are no such thing as "safety aids" when it comes to investing (that is, none that your broker will tell you about), and finally, you can't buy insurance on your investment, at least, it is NOT called insurance. No wonder people say investing is risky! I mean, would driving be risky if you allow any one who can afford a car, no matter how old or decrepit, onto the road, with no test whatsoever? With no insurance, and no safety devices whatsoever? I'd be scared to just walk on the street.

== Stock insurance, really? ==

The reason you never heard of insurance for stock market investment because it's NOT called insurance. It's called options.

You're probably wonder if I lost my mind, I assured you I haven't. Keep in mind options are QUITE complicated. You need to go pick up some books on options, such as "Options Made Easy", or "Trade Options on the Internet". Those will give you far better explanations.

Basically, by placing an option opposed to the expected direction of stock movement, you will not lose as much as you would have without the option.

First, there are two types of options... a call option is expecting the price of stock to go up, and a put option is expecting the price of stock to go down. Call up, put down.

So if you expect the price of stock to go up, you buy a put option to protect yourself against it going down. And vice versa.

The way it works is if your stock prices go DOWN instead of the expected up, your put option prices increase, which will offset (somewhat) your losses.  And vice versa.

For details, you need to check an options book, or my options primer, which I will post later.

TWO MORE THOUGHTS TO TAKE AWAY

NEVER trust information with only a SINGLE SOURCE. As President Ronald Reagan used to say, "trust, but verify", even if the information was handed down by your parents, your teachers, etc.

Yet another point: If you have an automatic reaction to something, and you're not sure WHY, it may be worthwhile to find out, and if necessary, cure yourself of that "knee-jerk" reaction.




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