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Risk Management

Prudent Investing vs. Chasing Growth and Meme Stocks

High volatility in investment returns can eventually lead to uncle point or even ruin. Long-term backtests or even actual records may look good on paper but returns of market participants depend on timing of investment.

No one is investing in a backtest or past performance but in the expectation that future returns will be comparable to past returns. Some may forget that the disclaimer “past performance may not be indicative of future results” doesn’t specifically refer to returns but to some measure of performance. The most widely used measure of performance in finance is the Sharpe ratio; its value depends on excess mean return and the volatility of excess returns over the investment period . Note that Sharpe ratio of 1 could mean excess return of 10% divided by 10% volatility or 50% excess return divided by 50% volatility.

Therefore, for most investors a high Sharpe ratio makes only sense in the context of volatility. A 10% volatility is usually tolerable but 50% volatility could lead to uncle point before the high returns are realized, if ever.

More importantly, performance depends on timing of investment. Let us look at the stock of Moderna Inc. (MRNA), which according to some websites had a high number of mentions recently to fit the definition of a meme stock.

Year-to-date return is 127% after rising as high as 364% on August 9, but the return since August 1 is -33%! The stock has lost 51% from all-time closing highs. Only this week it fell 31%!

Performance depends on timing of investment. The long-term performance of the newsletter or systematic strategy may not be correlated with the time-domain path of an investor. Chasing stocks with high volatility is risky speculation that can lead to severe losses. In a conservative investment program, MRNA stock would probably have an allocation of 1% or less.  Putting 100% in a stock like MRNA could be reckless speculation and even 20% or 10%.

Below is an expert from this week’s Market Signals report:

Most serious investors are in the market to generate sufficient return to cover loss of purchasing power due to inflation and also generate an income stream. Large gains are desirable but aren’t the main objective because they come with high risks. Financial social media and blogosphere are packed with speculators who chase large returns and think the market will make them rich. The fate of most is known.

Limiting risk per trade to about 2% and diversifying is what market wizards and successful traders and investors have shown to be the prudent path. By doing this, maybe the results won’t be spectacular and stock market buy and hold will be underperformed. But it’s the path that has higher probability of staying in the market and offers opportunity of compounding returns.

Charting and backtesting program: Amibroker. Data provider: Norgate Data

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