I was mulling over various concept column ideas, including risk, when I got an e-mail from Jim Lewis, a fellow believer in the use of finance and economic principals in playing HSX. Jim made the following statement and suggested I write about risk.

“We all got clobbered last weekend on MADCI and STARS, right? But most of us made out like bandits on IKNOW and DVADV. Unfortunately, I was full up (50K) on MADCI and only had about 30K each of the two arbs. Why? MADCI looked way more underpriced and promised a higher return per day. This makes good sense as far as I took it. What I forgot was basic finance. When valuing the cash flows associated with these investments, I didn’t account for the much higher risk of holding an opener (MADCI) through the weekend.”

Jim raises an excellent point. I did mention in my column last week that traders should invest in the arb stocks before STARS. I recommended this not because I thought STARS wouldn’t make money (I thought it would make more money than the arb stocks), but because there was greater risk associated with it. However, I didn’t explain the risk factor very well, an omission which I will now correct.

Most people are risk averse – they don’t like taking unnecessary chances with their lives or their money, unless there is a commensurate benefit (skydiving is very risky, but skydivers find it fun – a benefit). Therefore, anyone who wishes to sell you a risky investment opportunity has to offer you a greater benefit in order to get you to buy. In finance, the safest place to invest your money is usually considered to be short term U.S. Treasury Bills (which are shares of the vast Reag-, err… U.S. national debt). T-bills, as they are called, offer a “real” (meaning: “accounting for inflation”) return of around 5%. (I might be a little bit off here, I haven’t checked prices for a while). The short term T-bill rate is used as a benchmark for other financial investments.

The difference in the rates of return offered between T-bills and other investments is referred to as the “risk premium” – the higher rate needed to make up for risk. The riskier the investment – the greater the rate of return. For instance, 30-year T-bills offer a better return than short term T-bills because there is a greater risk of inflation in the long term. The (real) stock market offers an even greater return due to risk (stocks have grown at a “real” rate of about 10-12% a year since the beginning of the century, including the Great Depression, but their volatility is much higher – witness the wall street mess two weeks ago), and junk bonds, in their heyday, offered an even greater return, often in the high teens and twenties, since the risk of default was even higher.

So, how does this apply to HSX? Assuming you are risk averse, you should require a higher rate of return for riskier stocks, such as openers, when comparing them to safer stocks, such as arbitrage stocks like DVADV was last week. How much greater of a return? It really depends on you and the confidence you have in a stock. For instance, I didn’t have a whole lot of confidence in my prediction for STARS, so I explicitly used a 3x risk premium, requiring that STARS offer me three times the rate of return as the arbitrage alternatives before I would prefer STARS to DVADV or IKNOW, which were very safe. I used a 2x risk premium for MADCI, since I (incorrectly) had more confidence in my prediction. Since MADCI, even with the risk premium adjustment, had a better predicted return than the arb stocks, and STARS had a worse return, this made MADCI a better buy than DVADV and IKNOW, and STARS a worse buy. I ended up being right about STARS but wrong about MADCI. Still, if I had ignored risk, I would have lost 400k more on STARS.

One thing to keep in mind is that a risk adjustment assumes you don’t like risk. However, many people deliberately engage in high risk behavior that has a long term negative financial payoff, such as playing the lottery, because to them the excitement factor overcomes the risk. If your goal is to have fun, and you find waiting for the preliminary Saturday numbers exhilarating, not nerve-wracking, then you might want to ignore risk, or even prefer riskier stocks to safe arb stocks. Just remember that your portfolio will probably suffer for it.

Tom Miller