Risk Management

How will your capital be protected
while pursuing market beating returns?

Risk is managed through diversification, rebalancing, calm reassessment
in the face of new information, and disciplined adherence to strategy.

Knowing which risks to accept and which risks to avoid will produce better returns along with a sounder night’s sleep. The keys for managing risk are knowledge and psychological discipline. Before discussing risk management, we must identify the main sources of investment risks.

 

Economic and Political Risk is the main source of real fundamental risks. Market supply and demand and the government policies that affect these are the major determinants of economy wide profits and therefore returns on investments. Changes in taxation, monetary policies or regulatory rules all can have significant effects on financial results across the entire market. Analyzing the implications of events and trends and investing accordingly is the most significant source of excess return compared to buying and holding an index fund. The impact of these fundamental factors is generally spread out over longer periods of time - as real world events play out.

Market risk is the day to day fluctuations in valuations that have more to do with market mood swings in terms of risk tolerance. I.e. the greed and fear factors that cause price to earnings ratios to change significantly without news to justify such changes. Let’s consider an example. Apartment Investment Management Co. is a real estate investment trust (REIT). Its ticker is AIV. REITs are valued based on a multiple of Funds From Operations (FFO). A multiple below 10 should produce a good return for the risk. On March 30th 2009 AIV closed at $4.99 per share which was 2.8 times projected 2009 FFO. On May 21st 2009 AIV closed at $9.25, up 85% in less than 60 days. Earnings came out and the 2009 forecast was unchanged - so the multiple rose to 5.1. Nothing happened, except that market participants felt less risk averse and so were willing to accept lower returns for the same risks. Thus they bid up stocks to higher multiples with no change in economic factors. The reverse is also true. Market-sentiment-driven valuation changes are the second major risk factor.

Psychological Risks: many studies have found that human psychology is a source of risk because investors’ emotions and biases cause them to make poor investment decisions. From 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have accumulated more than twice as much money by simply buying and holding the average mutual fund, and more than three times as much by buying and holding an S&P 500 index fund. {Cumulative returns: individuals = 108%, mutual funds = 302%, S&P = 458%} There is something in most people’s nature which compels them to buy high and sell low. This is just one aspect of psychological risks.