Equity Valuation and Portfolio Management

RISK TO TRADING STRATEGIES

In investment management, risk is a primary concern. The majority of trading strategies are not risk free but rather subject to various risks. It is important to be familiar with the most common risks in trading strategies. By understanding the risks in advance, we can structure our empirical research to identify how risks will affect our strategies. Also, we can develop techniques to avoid these risks in the model construction stage when building the strategy.

We describe the various risks that are common to factor trading strategies as well as other trading strategies such as risk arbitrage. Many of these risks have been categorized in the behavioral finance literature.⁹ The risks discussed include fundamental risk, noise trader risk, horizon risk, model risk, implementation risk, and liquidity risk.

Fundamental risk is the risk of suffering adverse fundamental news. For example, say our trading strategy focuses on purchasing stocks with high earnings-to-price ratios. Suppose that the model shows a pharmaceutical stock maintains a high score. After purchasing the stock, the company releases a news report that states it faces class-action litigation because one of its drugs has undocumented adverse side effects. While during this period other stocks with high earnings-to-price ratio may perform well, this particular pharmaceutical stock will perform poorly despite its attractive characteristic. We can minimize the exposure to fundamental risk within ...