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If 2 people invest the same amount in the same asset at the same time, will their risk be different if they use different risk management strategies?

Say Inventors A and B both buy 1000 shares in company ABC at $10 per share ($10,000 purchase plus brokerage) on the same day.

Investor A is happy to make a 10% profit and then sell the shares straight away. However, if the shares start dropping Investor A is happy to keep holding the shares long term and get the 5% dividend yield on them until the 10% capital gain is achieved.

Investor B, on the other hand, prefers to use a stop loss strategy instead. Investor B puts a stop loss on the shares at 10% below what they were purchased at ($9). If the shares drop to $9 investor B will sell all the shares. However, if the shares start to rise, say to $12, Investor B will raise the stop loss to $10.80 (10% below $12). If the shares keep on rising, Investor B will keep raising the stop loss level accordingly, however if the shares drop the stop loss will not be moved.

Are both Investor A and B taking the same amount of risk, or has one of them changed their risk level due to implementing their risk management strategy?

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3 Answers

The risk of the particular share moving up or down is same for both.

however in terms of mitigating the risk, Investor A is conservative on upside, ie will exit if he gets 10%, while is ready to take unlimited downside ... his belief is that things will not go worse ..

While Investor B is wants to make at least 10% less than peak value and in general is less risk averse as he will sell his position the moment the price hits 10% less than max [peak value]

So it more like how do you mitigate a risk, as to which one is wise depends on your belief and the loss appetite

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The risk for each investor is related to how much capital they are willing to lose in order to make a profit, is it not? –  Victor Sep 25 '12 at 12:17
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Yes definately, not just how much they are willing to lose in order to make profit, but also how much more profit they want to make ... –  Dheer Sep 26 '12 at 3:36
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So Investor A is risking $10,000 to make $1,000, whilst Investor B is risking $1,000 to potentially make unlimited profits. So who then is taking the bigger risk? Investor A, is it not? –  Victor Sep 28 '12 at 10:30
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In absolute terms yes investor A is risking too much ... if you add probability factor then its different ... just to give an example 2 friends enter into a bet whether 1000 men pass together outside the window ... if they don't do, A will pay B $ 1. If do then B will pay A $1000. So from an absolute loss prespective A will loose max of $1, while B will loose max of $1000 ... so B is more risky ... however the probabilty of it happening is very low ... hence B may make money while A may loose ... –  Dheer Sep 28 '12 at 11:00
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I think if a stock falls by 10% quite quickly, the probability of it falling alot more is increased considerably, and there is no telling how far it can fall. (A bit different to your example). When the market changes direction it usually continues in the new direction for a good period of time. That is why buy and hold investor lose quite a bit of their capital during a market crash, because they have no exit strategy or no risk management strategy. –  Victor Sep 28 '12 at 11:13
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The other example I'd offer is the case for diversification. If one buys 10 well chosen stocks, i.e. stocks spread across different industries so their correlation to one another is low, they will have lower risk than each of the 10 folk who own one of those stocks per person. Same stocks, but lower risk when combined.

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But also lower potential returns, and if you only had $10,000 to invest it will not go very far in buying 10 different stock! –  Victor Sep 25 '12 at 12:21
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The downvote - does a member here not believe diversification lowers risk? –  JoeTaxpayer May 13 '13 at 0:16
    
It wasn't me Joe, but diversification wasn't really part of the question I asked. It was more to do with the comparison of the risk in how 2 investors would manage the purchase of a particular stock holding. Both might hold a diversified portfolio of stocks, but the question is more on how they manage each individual stock (regarding risk and return). –  Victor May 13 '13 at 1:36
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+1 Savvy investors assess the total risk of their portfolio and manage the total risk accordingly. You asked "If 2 people invest the same amount in the same asset at the same time, will their risk be different if they use different risk management strategies?" and the answer is definitely yes. A standard risk management strategy is diversification into assets with low cross- and cross/lag correlations, so it isn't wise to automatically discount such a strategy. –  John Bensin May 24 '13 at 1:08
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In a perfect market, share prices are by definition a perfect reflection of the true value of a share. Hence, you always get $10 for a share that's worth that much. In reality, the market is imperfect. Prices are somewhat of an average of all different estimates, and there's a cost-of-trading margin between sales and buy prices.

Hence, in a perfect market it doesn't matter whether you have a stop loss order at $9.00. That just trades your stock worth $9 for cash worth the same $9. In an imperfect market, that trade nets you less.

Furthermore, is risk a linear function of money? Perhaps not, if you bought on margin, need to lend extra and your interest rate increases with the extra credit demand.

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I am not sure what you are on about in the first part. Regarding buying on margin, the question does not mention anything about buying on margin, but even if they both bought on margin, say 50%, their potential loss in $ terms would be the same (not including interest payments). The most A could lose is $10,000 and the most B could lose is $1,000 (possibly more if there was a gap in the market unless he/she used a guaranteed stop). The % on their initial capital invested would be doubled however. –  Victor Sep 28 '12 at 10:39
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The margin I mentioned in the first paragraph is also called the spread; the difference between sell and buy prices. It's not about buying stocks with borrowed money. Also, in a perfect market price changes are instant. A stop loss order can in fact sell stock for less than the execution price in such circumstances. –  MSalters Sep 28 '12 at 11:33
    
Regarding margin, I was referring to your last paragraph. Regarding spreads, I realise that less liquid markets can gap a lot which is why I mentioned if someone was concerned about the price gapping and not getting the stop price they were after then they could use a guaranteed stop loss. I use stop loss orders often in my trading and 80% of the lime I get the exact price of my order. Out of the other 20% only about 10 to 20% gap more than 1% from my stop price. So I find the extra loss due to slippage and gaps is minimal and don't warrant using guaranteed stops. –  Victor Sep 29 '12 at 1:42
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