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Loss Frequency v. Loss Magnitude - A Financial Risk Management Lesson

Posted on the 06 April 2013 by Wallstlawblog @Wallstlawblog

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By  Brett Sherman

The Sherman Law Firm

In finance, risk is the chance that an investment decision or strategy will result in loss.  Any analysis of risk must consider two major elements

FREQUENCY OF LOSS andMAGNITUDE OF LOSS

 

First, defining terms:

Frequency refers to how often an investing or trading strategy generates losses. 

Magnitude refers to the size, or severity, of potential losses. 

 A profitable strategy that generates losses most of the time?  Sure.

Some really good investing or trading strategies result in losses more often than profits. Suppose, for example, that hyothetical Plan X results in a $10 loss 80% of the time, but a $100 profit 20% of the time.  So, 8 out of every 10 times you attempt the strategy, your expectation is that you will lose $10, for a total loss of $80 dollars.  However, if your expectation holds true, you also will make $100 two out of every ten times the strategy is executed.  

Thus, Plan X is risky from a frequency standpoint because you will lose money most of the time.  However, as long as you can afford to take losses and keep pursuing the strategy, Plan X is still a pretty good gamble because your expectation is that it will pay off over time, generating - on average - a net profit of $120 for every 10 times the strategy is used.  

 A strategy that is almost always profitable can still wipe you out.

 Some investment or trading strategies are extremely risky even though they rarely produce losses. Take, for example hypothetical Plan Y, which - on average - produces a $10 profit 90% of the time.  

A 90% success record sure sounds good.  But, if Plan Y results in losses of at least $500 roughly 10% of the time, then the strategy's risk magnitude (potential for large losses) makes it a bad long-term bet.  Why?  Because, for each ten times you execute Plan Y, you expect to suffer a net loss of$990 or more.  

 

Of Short-term Genius and Long-term Disaster

Now, suppose that Trading Desk A1A follows Plan Y for 5 years.  In each of the five years, the Trading Desk A1A makes money for its parent company.  This is no surprise, because Plan Y is profitable 90% of the time.

After five great years, the Company proudly points to its track record of superior performance.  To the investing public (which is ignorant of the fact that Plan Y will eventually generate high  losses), the Company seems to be thriving.

In year 6, the Company's luck begins to run out.  It loses $300, not as bad as the expected loss of at least $500, but still a big enough loss to put the Company on shaky ground.  In year 7, the Company decides to allow Trading Desk A1A to stick with Plan Y.  After all, the investment strategy is almost always successful.  Unfortunately, year 7 is another bad year.  This time, the Company takes a $500 loss.

For the Company, the size (magnitude) of the losses in years 6 and 7 proves to be  catastrophic.  The Company avoids bankruptcy only because JPMorgan Chase agrees to buy the Company for $2 a share.

Disclaimer- this is a hypothetical situation, any similarities to real world events are purely coincidental! 

 

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