One of the questions that comes to us often is about the difference between stock risk and portfolio risk. We’ll look at the differences and the effect they have on your investment success.
In this article, we’ll focus on stock risk and some of the comparisons you can make between different stocks. Next week, we’ll look at portfolio risk and how individual stocks work together within a portfolio.
Individual stock risk is fairly straightforward and easy to understand. Each stock or fund has its own risk profile.
The term we use to describe this risk is “Volatility Quotient”. When looking at the Volatility Quotient (VQ) of a stock or fund, we talk about the VQ% of a stock. It represents the normal volatility one can expect over a one year or longer timeframe.
The VQ can be used to understand the volatility of a single stock and it can be used to compare the volatility of different stocks. An example that we use often is comparing a stock with a low VQ% to a stock with a high VQ%.
Type in a ticker, in this case JNJ (Johnson & Johnson), and the VQ pops right up.
Of course, JNJ is a fairly conservative stock and has a low VQ. From an investor’s point of view, the VQ of 11.58% means that if you own JNJ, it can move against you by 11.58% and still be within its normal range of volatility. If it moves against you by more than this amount, then that is the signal to exit the position.
The gold mining stocks are more volatile and their higher VQs reflect this. Here’s a look at the volatility of ABX (Barrick Gold).
What is the takeaway here? Let’s assume that you normally use a 25% trailing stop. If you invest in JNJ, then you’re letting the stock run more than double its normal volatility before it hits your stop. This could really damage your portfolio.
On the other hand, if you use a 25% trailing stop for ABX, you risk stopping out while the stock continues to trade within its normal range of volatility and negate the potential upside of stocks with high VQs. This could limit the potential profitability of your portfolio.
One of the important decisions for you as an individual investor is to determine how much risk you’re willing to take in any stock. If you make the decision that you’re not willing to take on too much risk, the VQ can help you with your investments.
Let’s assume that you have made the decision not to take on more than 20% risk in any one position. By knowing that the normal volatility of ABX is almost 42%, it’s easy to make the decision to not invest in ABX as its volatility is more than double what you’re willing to risk.
The Volatility Quotient is a dynamic number and it changes every week. The changes aren’t large, but you can track them on the same Stock Analyzer page. Over the course of time, though, the changes can be significant.
Knowing the direction in volatility and if a stock is becoming more or less volatile can help you with your decision-making.
As the VQ% is adjusted each week, so is the underlying stop loss on each stock. For instance, if a stock becomes less volatile over time, then the stop loss for that stock will be adjusted upwards automatically. However, if a stock becomes more volatile, there will be no adjustment made to the stop loss.
Next week, we’ll focus on portfolio risk and look at the portfolio tools that are available on TradeStops. In the meantime, we have created a short video that discusses the difference between stock risk and portfolio risk. Here’s the link: Stock Risk vs. Portfolio Risk in TradeStops
If you have a question, please send it to [email protected] and we’ll get you an answer quickly.
To understanding and controlling your risk,
Education Director, TradeStops