Morgan Stanley’s fourth quarter results are the most remarkable I’ve ever seen.

Last time, I talked about John Paulson’s mega profit from shorting subprime. While Paulson’s team was putting together a series of trades that gained $12 billion, their competitors at Morgan Stanley were putting together trades that have lost over $9 billion.

What’s remarkable is that Morgan Stanley’s record breaking loss came from a trading desk that took the same view of subprime as Paulson – they looked at the sector and saw a dog with fleas that was crying out to be shorted. Having seen this, they then constructed a trade that, in three months, lost them over $9 billion.

In this context, it’s easier to see the truth of Arpad Busson’s comment that the great merit of Paulson’s trade lay in its execution.

So how did Morgan Stanley’s traders manage to make record losses out of a correct prediction of subprime’s downfall?

The losses stemmed from the fact that they did not fully understand the debt market they traded.

Morgan Stanley’s team shorted subprime but hedged by going long supposedly solid AAA debt. The theory was that, if their short went against them, their long position in AAA debt would rise and cover the losses. They put approximately $2 billion into their short position and $14 billion into their long position.

The mistake the traders made – and they were not alone – was that although their long position was in supposedly AAA debt, this debt had been constructed from BBB debt using credit default swaps – known to those in the business as mezzanine.

According to Portfolio.com – who give a simple, animated explanation of how lower quality debt was transmuted into high quality AAA debt – financial professionals thought that BBB debt could be elevated to AAA through “diversity”: If borrowers were defaulting in Florida, they could still count on payments from California. But over the last year, different kinds of mortgages defaulted at the same time – leaving no money even for the supersenior AAA tranche, which was meant to be completely safe.

In fact, the AAA debt Morgan Stanley bought as a “hedge” is now worth only about 30c for each dollar they paid.

Although they’re putting a brave face on it – trying to spin it as improving their links with China - in order to remain sufficiently capitalized, Morgan Stanley has been forced to borrow $5 billion from the China Investment Corporation. The $5 billion comes at a high price – the Chinese are charging 9 percent interest. In a couple of years’ time, this debt will convert into CIC owning 10 percent of Morgan Stanley.

John Mack, Morgan’s chairman, says he is embarrassed by the results and Morgan will be reigning in its risk taking in future trading.

You can listen to Morgan Stanley’s webcast and Q&A session. (Until late January).

Portfolio managers talk about risk not in terms of loss but in terms of variability of their returns. This way of looking at risk can also be valuable to stock traders.

Jesse Livermore, one of the world’s most famous speculators, was known for plunging - risking all of his available assets plus a large margin from his brokers in single trades. In addition to making fortunes, he lost them too. Although Livermore’s trading tactics are as relevant today as when he used them, his management of risk often left much to be desired.

Risk

You take a risk every time you drive to work or cross the street. You take a risk when you dine out. You take a risk when you trade shares hoping to get rich.

What Does Risk Mean?

Each example above describes an action you take to get something you want. However, there is also the possibility of an outcome you don’t want - be that serious injury in a car accident, food poisoning in a restaurant or losing money in your stock-trading activities.

To trade stocks successfully, you need to understand risk.

To professional portfolio managers, a high-risk portfolio is one in which the returns are highly variable.

For example, here are the five-year track records of two stock portfolios:

Portfolio A Performance Summary

• Average Annual Return +39%
• Annual Compounding Rate +31%

Portfolio B Performance Summary

• Average Annual Return +6%
• Annual Compounding Rate +6%

Portfolio A, compounding at an average rate of +39% per annum, would be described as high risk, because the annual rate of return is highly variable.

Portfolio B, compounding at an average rate of +6% per annum would be described as low risk, because the annual rate of return changes little from year to year.

The portfolio manager’s definition of risk seems to be lacking because it fails to see the ‘risk’ that your rate of return is lower than you expected. There is a high ‘risk’ that you will not grow wealthy with Portfolio B.

On the other hand, how many of us would have the nerve stick with a portfolio (or a trading method) like A, that lost 20% of our funds in its first year? To that extent, we can sympathize with the portfolio manager’s definition of risk.

To further examine this definition of risk, which trading strategy would you rather follow from the two below? Which of the two would you be most likely to stick with after sitting down after the first year and reviewing your performance? Be honest now!

Results: $100,000 allocated to A will grow into $380,160 while $100,000 allocated to B will grow into $381,164.

Traders following strategy B would sleep more easily at night than those following A. Furthermore, many beginning traders using Strategy A would give up after their first year, believing their trading skills to be poor, even though Strategy A would reward them handsomely over a longer period of time.

For this reason, when you are choosing your first trading strategy, it’s important to consider variability of return. When you are testing strategies, you should select those which offer good profits AND have low variability in yield. This will allow you to build confidence in your methods. Later, you may be happy to accept higher volatility in pursuit of higher returns.

Jesse Livermore, one of the greatest stock traders in history, made his biggest market killings when he shorted stocks. In particular, he made $100 million (worth more than $1 billion in today’s money) when he shorted the market in 1929.

Non-expert traders should be reluctant to short stocks though, without very great cause. Here are some reasons why short trades are riskier than long trades:

Why you should think Twice Before Shorting

1. When a long goes against you, your position size falls. When a short goes against you, your position size rises, increasing your risk.
2. A rising stock market serves the interests of society’s most influential people - business owners and governments. They will lobby and legislate for conditions in which businesses and wealth creation can prosper. Notice how central banks cut interest rates when economic conditions take a downward turn.
3. Business owners and managers work hard to make their businesses succeed. Their desire to increase their profits usually results in rising stock prices.
4. The long-term charts of the Dow, S&P500 and the NASDAQ reflect points 2. and 3. The long-term direction is upward. When you short, you go against the natural, long-term market trend.
5. Long positions can result in 100% loss of your stake. Short positions can lose you an unlimited amount.

Every serious trader should have shorting as a stock trading tactic – but it’s a tactic that requires greater caution than going long.