Risk Management

So how will I protect your capital while pursuing market beating returns? I manage risk through diversification, rebalancing, calm reassessment in the face of new information, and a disciplined adherence to strategy. I also use inverse index exchange traded funds to hedge in times of increased downside market risk. I will explain.

Diversification means spreading out your money so no single investment can cause a “significant” loss all by itself. We have 3 ways to pursue diversification. Most importantly, a client’s portfolio will include many different stocks and no one company will account for more than 10% of the total client portfolio value. Second, the use of exchange traded funds (ETFs) to invest in a specific industry or country provides diversification because these securities represent investments in entire portfolios of companies within the target sector or country. There will be different portfolios for different risk tolerance and objectives. Thus a final source of diversification is spreading money out across more than one of these “risk strategy portfolios”. 

Rebalancing refers to selling assets that have risen and investing in those that have fallen in value so as to hold the individual positions somewhat stable as percentages of the total portfolio value. Notice what this policy calls for: selling high and buying low. This is the most basic rule of making money. It’s also the opposite of what most people seem to actually do. Discipline is needed because buying something that has been declining brings emotion (regret, fear) into the decision process. Likewise selling something that has been good to us can also go against our emotions. Of course, there will be some constraints on sales of winners to avoid situations where the resulting tax liability negates the gain from diversification. As I will discuss next, there will also be some cases where we should sell a declining stock.

We do not want to add to holdings of a declining stock when the decline is for a good reason. Thus, when new information comes out that causes a price decline, we must analyze the new information to determine if it changes the likely returns of the stock going forward. We must be calm in reassessing the situation. When emotion and panic drive the rest of the market, those who keep their wits make all the money!

There are times, however, when economic and/or market conditions are such that expected returns on stocks are outweighed by the increased risk of overall market declines that can drag down all stocks – good and bad. Our risk management strategy in this situation, is to buy exchange traded funds (ETFs) that perform opposite to the broad market indices and thereby insulate our clients’ holdings from broad market risk. We can still expect to profit and outperform short term bonds because our individual security selections should generate significant dividend income even if capital gains and losses are neutral. For example, we recognized such a situation at the beginning of 2008 and created hedge portfolios for clients. The Ultrashort S&P 500 Proshares are an example of one of the ETFs we use in this hedging portfolio. Thanks to these positions, clients had positive returns in the first six months of 2008 even while the S&P 500 was declining 11.9%.