Risk management is the most important task of a money manager. You’re probably aware of last week’s a selloff in the stock market. I think this type of market action motivates people to look at their portfolios. I say, at all times, it’s important to look at your day-to-day performance so that you are prepared for times like last week and more importantly, to be ready if volatility increases even more.
“How Much” Is Just as Important as “What” to Invest In
I read a book some years ago called Trading Risk: Enhanced Profitability Through Risk Control, by Kenneth L. Grant. I highly recommend reading this book if you are serious investor or trader. The book describes many practical concepts of managing risk and how you can actually enhance your overall upside performance through basic guidelines. To me, risk control is even more important than your investment philosophy. I say this because if you don’t manage your investments within your risk profile you probably will abandon a strategy at the wrong time. It also drives how much money is put in investments. Answering the question of “how much” is just as important as “what” do I invest in.
Self-Reflection Could Improve Outcomes
It’s really helpful to look back and ask yourself “How can I improve what I do?” I’m a member of an organization called Strategic Coach and one of the thinking tools we use is called an Experience Transformer. The tool helps you think about an experience, good or bad, and isolate what worked in that experience what didn’t work. You then ask yourself “given what I know now, what would I have done different?”. You then have the raw materials to make changes to your policies to have a better outcomes in the future. I’ve found this to be an invaluable thinking tool and I really like to apply it to risk management.
It Starts with Analyzing the Daily Performance in Detail
If you look at your performance on a day by day basis, it’s amazing what you will find. You’ll find when you’re increasing and decreasing the volatility of your portfolio and if it was at the right time or the wrong time. You’ll see which one of your holdings were working well, and what you could have done ahead of time to avoid some pain and capitalize more on your winners. You will get ideas on how to manage capital to make money in more scenarios.
Setting Objectives to Establish Guidelines
The first analytical tool is a time series profit and loss statement. You want to be able to see your P & L over time, preferably day by day, and then roll it up to weekly, monthly, quarterly, and annually statistics. When you look at it over various time frames, you can see your results much better. You want to look at the returns themselves, the volatility of the instruments that you are trading or investing in, and the correlations and how they’ve interacted with each other over that timeframe. Measuring those parameters helps you get a clear picture where returns and risks are coming from.
It’s important to have predefined objectives. The three most important would be 1) Your nominal or minimum return target, 2) your optimal or best-case return and 3) your stop out level or maximum risk over a specific time frame.
The first objective would be your nominal requirement to return. What is that return that you’re looking to get as a minimum? You should be able to achieve this objective even though you don’t have control over the markets. You do have a lot of control over your position sizes, what you pick, and your adjustments that you can make along the way.
It’s really good to look at the environment and ask, “what is the environment going to give me?” For example, the earnings yield is somewhere around five percent on the stock market right now and, 10 years trading at around a three percent. Given your allocations and what you’re looking for, you should be able to hit your nominal return, and how you construct your portfolio is really important.
The second thing you want to look at is your optimal return. What if everything is just right? If all conditions are right for how you invest and how you trade, what is that optimal return that you can hit? You need a stop number, over a given time frame, whatever that may be – what is that level of maximum risk that you’re willing to accept over that time horizon? Establishing that is crucial. Beyond that, how are you going to execute? You have to fight for great execution because trades have to be done in a timely manner and they need to get good pricing. This is important because all of these things that you do at the margin really determine how well you’re going to do. So getting better pricing, paying less in commissions and having less slippage; these things really make a difference.
Maximum Risk Over a Specific Time Frame
The other objective to set is your stop out level. We want to establish a predetermined level for maximum risks for positions, groups, and the overall portfolio over a specified time frame. What are your targets and your stop levels? When you’re looking at an opportunity, if you’re not assessing the reward/risk opportunity before you place your hard-earned capital, it’s very difficult for you to size positions. It’s one of the things that you have to know. Reward/risk ratio is one of those trade trading parameters that you need to adhere to. You need to know the daily volatility that is acceptable and an what point is it too high. You also need a minimum amount of risk in order to achieve your objective. Too little risk will ensure you don’t high your return targets. Too high risk will inevitably get you caught in a volatility vortex that will hurt results. It’s a balancing act.
Keeping In Your Comfort Zone
That’s one of the biggest lessons in risk control – getting outside of your risk tolerance might work one or two times, but eventually everyone gets caught. If you get caught beyond your risk profile, it’s very difficult to make it up from there.
The next thing would be comparing your decision-making criteria during periods of strong performance versus weak performance. Ideally what you want to be doing is increasing your volatility to some extent – you don’t want to have too much expansion and contraction, but you want to be able to capitalize when the conditions are right. When the conditions aren’t right, you should be pulling back a bit on your risk.
Dry Powder for Innovation
You always want to have a little bit of risk budget set aside for innovation. You want to try new things because the market is always changing. Take some of your risk and set it aside so when you’re having a good period, you take a little bit of your risk capital that you normally would have put into your process and you reserve that for innovation.
Dry Powder for Outstanding Opportunities
Reserving risk capital for unique opportunities is another critical thing because every now and then there’s something really one of a kind that happens and you want to be able to have some dry powder so that you can use that risk budget to take advantage of it. Something that happens to most investors and traders is when they see the opportunity that’s staring them in the face, they don’t have the risk capital to use it because they’re in a drawdown in performance. Having that extra risk set aside is super important. You keep a portion of your profits so that you can redeploy it.
Recognize Your P&L Cycle and Adjust
Stan Druckenmiller recently had an interview on a research platform and he said it’s most critical to know when you can see the ball and when you can’t see the ball. When you’re not seeing the ball and not clear on what where the market is headed, you need to reduce exposure. The opposite is also true – when you’re seeing the ball, increase exposure. This shows up in you P&L statement. If profits are increasing you can take more risks, if its falling it best to take smaller risk and work your way into profits before getting overly aggressive.
You might trade smaller when you’re not doing so well. You might cut trade sooner and you don’t want to press your bets at the wrong time. Probably the biggest thing that hurts performance is when you start pressing bets because you get overconfident at the wrong time. I’ve had this in my performance and I think everybody has, and this is something that I believe this is happening right now in the marketplace. More and more people are pressing their bets because it’s been easy. There’s been a strong stock bull market and people are pressing their bets and they’re outside of the risk parameters in many cases. Not everybody – I know this is a generalization, but it is something that what I’m seeing.
Minimum Risk to Reach Goals
Another important thing to remember is you have to take enough risk to meet your goal. If you’re not taking enough risk, what’s going to happen? You’re going to wind up underperforming, even if you hit everything right, there’s not enough volatility in your portfolio for you to actually hit your number. It’s vital to take enough risk to make improvements at the margin. What is your execution? How are you trying to get better execution? Lowering those commission costs, your risk management, more precise risk management and sizing, and better research. Those are the four big things that all compound. It’s like it’s like stacking dimes – they compound up. There’s a profit and loss cycle, it can be up or down. You need to know where you are and trade accordingly.
A good thing to keep in mind is to not rely so much on participants to comfort you. A lot of professionals that I know listen to other research firms and there’s nothing wrong with that, but I do find that it’s almost used as a drug. It’s almost soothing to hear some other analyst or research outfit telling you what you want to hear and talking up your book. But that’s not what you want. What you really want is to have seeking the truth as your ultimate goal. This brings to mind Ray Dalio – he has a whole process in his firm that deals with seeking truth and that means seeking truth with people.
To sum up setting performance objectives and targets and watching your daily performance is the best starting point. You want to know what your minimum target looks like and what it looks like if everything is on full cylinders. Something that I think people overestimate is when they back test the solution and they see Sharpe ratio that’s one to one, where the return is about the same as the risk, and those are very difficult to actually achieve over the long run with a positive skew or even a flat skew. Generally, when you do these tests like that, there’ll be negative skew types and those generally have some bigger risk embedded in them.