Introduction to Risk Analysis

Risk analysis of stocks, which is also known as risk management, is an important component of stock investing. While fundamental analysis is performed on a company in order to determine its future profitability and hence its stock price appreciation potential, risk analysis is performed to manage the risks associated with stock investing.

Thus, fundamental analysis determines the company’s profitability and risk analysis determines the stock investor’s profitability.

While it is comforting for the stock investor to assume that the fundamental analysis they diligently performed on a stock will lead to their expected outcome, the reality is that fundamental analysis does not guarantee that the company’s future earnings will materialize as expected or indeed that the stock price will appreciate as anticipated.

Fundamental analysis is only a tool that is used by stock investors in order to determine the likely future outcome for the company’s earnings. Without risk analysis, the stock investor has no idea whether their portfolio will be profitable in the years to come. Investing based on hope rather than quantitative analysis is the prime reason why investors lose heavily when the first market correction comes along.

Pricing Behavior of Stocks

It is prudent for the stock investor to first thoroughly understand the pricing behavior of stocks, as this provides a sound basis for understanding risk analysis. Specifically why stock prices react and fluctuate the way they do, which is often contrary to what is expected to happen. Pricing behavior of stocks deals with the following:

  • Why Stock Prices Fluctuate
  • The Stock Price Roller-Coaster Ride

Once the investor has a grasp on these concepts, risk analysis will make more sense.

Risk Analysis Techniques

Risk analysis incorporates a number of quantitative analysis techniques as follows:

  • Risk Reward analysis
  • Market Cycle analysis
  • Portfolio Diversification
  • Stock Position Sizing

The following articles in this series on risk analysis will go through the pricing behavior of stocks and the risk analysis techniques, which will allow the stock investor to make a more informed investment decision based on risk management.