IPO Investments and Risk Management

Investments by their very nature, as opposed to shorter term trades, require us to take on more risk, and so much that it can certainly be challenging to manage effectively. The more room we need to give our investments on the downside, the more risk is present, and investments do require quite a bit of room.

Investors have been well trained to think in the opposite way, that the longer you are prepared to hold something the less risky the investment is, where trades or a shorter duration are somehow riskier. This is a preposterous notion though but one that remains quite popular, even among many who are looked up to and may even be considered experts in investing.

IPO Investments and Risk ManagementIt is important to have a good idea of what risk is when we speak of risk with holding securities, because it is hard to manage something you don’t understand. The risk here is that the value of our positions will decline by various amounts, and the more potential there is for this, the more risk there is.

Managing risk or even paying attention to it isn’t something those selling investments want us to be doing though, because they don’t want us doing anything besides just holding the investment regardless. This requires that we just ignore risk, by definition, because this is exactly what the strategy of just holding something is.

When we do look to manage the risk of an investment in some way, the degree of management will be reflected in how far we will allow the investment to go against us before we bail. The further we are prepared to go, the more risk we are taking on.

We can understand this in terms of the percentage of a decline that we’re willing to accept, and whatever other criteria we implement, this is really where risk will be measured, and therefore needs to be considered fundamentally. If not, we are making decisions that may or may not pan out based upon hope, and when our hopes do not pan out, how much we are prepared to lose may come to pass, and this is what we need to address when considering risk of loss, the actual loss that is risked.

Risks of Particular Investments

We might think that by investing in securities that we consider to be less risky by some other measure, such as beliefs that we may have in the company’s future prospects, may be managing risk, and while it is true that we can select more or less risky stocks to invest in, those that are more or less volatile for instance or ones that are less proven or stable, this is only part of the picture, but still one that needs to be accounted for.

Some investments are by nature more risky, a new company for instance, or one in a sector that tends to be more volatile such as what are considered to be growth plays or ones in so called emerging markets.

IPOs are among this class of investments that are seen to be by nature more volatile and therefore more risky, and IPOs are certainly more volatile generally than more established stocks.

There are two components to addressing risk with investments, which are assessing the inherent risks involved, the things we do prior to making the investment, and managing the performance risk of the investment after we have invested in it.

Whether or not an IPO or IPOs in general are suitable to our risk appetite is the starting point, but this isn’t always that easy to do given that there is more uncertainty with IPOs than with established stocks.

Should we decide that these conditions are suitable for us, that the particular IPO investment makes sense, then the second component of this process then kicks in, which is how we are going to manage the risk of the IPO investment when we are in it.

Assessing initial risk is certainly an important part of the process, but if this is seen as an end in itself, as it generally is, we then are subject to being left to hope that our analysis is correct, and are left with no real plan should it not be.

This is why ongoing risk management is so important to investing, because it provides a safety net of some degree where the investment will be assessed on a continual basis and allow for our losses in the investment to be subject to limitation.

The Particular Challenges of Managing Risk with IPOs

Investments both need an entry plan and an exit plan, and it makes no sense to put all of our efforts into the entry plan, in this case selecting an IPO with better than average potential along with an initial risk profile that we find suitable, only to jump in and cross our fingers that this will all work out well for us.

We need to plan the entire trade when we invest in any stock or any other sort of investment as well. If we are going into business, this risk is present, but typically our exit strategy will be to fight to the end and only allow the failure of the business to take us out, but securities are different, and need to be approached differently.

The beauty of securities is that we can liquidate our positions very easily, even in times of extreme turmoil, where you’d be hard pressed to ever sell a business that is failing. We can therefore limit our risk to however little or however much we wish to take on, where we can exit our positions if the conditions dictate.

Coming up with an exit strategy does take both effort and skill though, and as it turns out, not a lot of investors are willing to make the effort or have the skill to come up with a good plan, and therein lies the dilemma.

With IPOs, the stakes are raised due to the greater volatility and risk that these stock investments possess, and if one is going to blindly invest in them, the potential for losses is intensified.

Some think that if we just do nothing then the risk will just go away, until of course it does come home to roost and investors are now wondering what to do, and may at some point act and be very prone to making mistakes.

We can say that the bigger mistake is not paying attention to risk in the first place though, where further mistakes such as dumpling our stocks near the bottom and seeing them come back later and not re-investing is just a manifestation of this bigger mistake.

With investments such as IPOs, or any investment that is more volatile than average, the increased potential for volatility will require us to be even more diligent with managing the risks than normal.

In practice, the normal amount investors use is practically zero, because risk management is not a strategy that investors tend to use, and they also tend to not use them with riskier investments such as IPOs either.

The reason why this amount is practically zero is that some investors do answer the bell if things get bad enough, when things have deteriorated to the level of what is then perceived as a crisis, and the starting point needs to be for investors to realize that this is not the best way to manage risk, and may only be superior to doing absolutely nothing ever, and sometimes is even worse than that.

There is the risk that whenever one makes decisions to exit positions then this may not be performed at opportune times, which we consider to be trading mistakes in the world of short term trading. Trading mistakes is the demise of many traders, and investors have even less skill on average and are even more prone to these mistakes.

How Risk May Be Managed Properly with IPOs

The good news is that we can manage the additional risk with IPOs and look to take advantage of their greater potential for returns without throwing risk management out the window, and instead looking to manage it appropriately.

Perhaps the best rule of thumb in trading is that traders are very well advised to exit trades when the performance of the trade does not meet their expectations. Put another way, if the reason why one entered the trade becomes violated, it’s time to go, and we need performance to drive our wanting to stay in it and not hope.

Hope is the enemy here, and when we get down to hope, or even allow hope to influence us at all, this is where we get into trouble. Trading and investing is challenging enough when we faithfully measure our progress by objective standards, but when these standards become violated and we hope things work out anyway, we are acting foolishly and taking on considerably more risk as well.

If we buy something and expect it to go up, like an IPO, and this doesn’t happen, we may need to re-assess what is going on and make sure that our original ideas with the investment are still probable. When the opposite, the investment not working, becomes more probable, then it doesn’t make any sense to stay with it.

Both trading and investing involve looking to take advantage of probabilities, and both involve potential gains and losses of certain magnitudes. Keeping the losses in check is the province of risk management, which is a combination of our being able to withstand the drawdowns while the probabilities remain on our side.

If either condition is violated, if the losses exceed what is reasonable or the probabilities shift against us, it is time to get out of the investment. People tend to hate exiting with a loss as they perceive this as a defeat of some sort, a mistaken investment, and perhaps it was, but the quality of one’s investments need to be measured by the way we handle them, and not necessarily their results.

Perhaps the most harmful attitude though is not seeing losses as losses unless they are booked, where if one simply hangs on to bad investments losses aren’t realized even though the investment may continue to deteriorate.

The risk of an investment does involve paper losses as well though because we’re looking to protect ourselves against these sort of risks. Shorter term movements in a long term horizon may not seem to mean that much, but if they are of a sufficient magnitude, they do need to be paid attention to.

IPOs do require closer management than normal stock investments, because they move more, and they can both move up and move down more. Just because we have booked very nice profits doesn’t mean that this attention is no longer required, as risk management both involves protecting against real losses and relative ones as well.

It may especially be the case with IPOs that we want to manage the risk of our not giving back too much of our gains, since IPOs do have the tendency to gain nicely initially, but this often does not continue so nicely.

Managing risk properly with investments in general and especially IPOs is by no means easy, but unless we at least pay attention to this very important component of investing, we may end up paying a lot bigger price than we should have if we were more diligent.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.