Picture yourself with a dozen of the world’s greatest traders and hedge fund managers, asking them collectively the one question on many an investors’ minds. “What’s your number-one rule for achieving consistent and long-term investing success”? The answer can be found in the epilogue of Jack Schwager’s immortal classic Market Wizards: Interviews with Top Traders”. The one consistent trait shared among them is their unequivocal approach to managing risk. Practising sound risk management is one of the most frequently cited attributes found amongst the world’s trading and investing elite.
Warren Buffet, one of the richest and most successful investors ever, has two rules for investment success. His first rule is: don’t lose money; his second rule is – don’t forget his first rule. Although a somewhat tongue-in-cheek approach to risk management, the crux of his argument is to guard against debilitating losses that can devastate a portfolio. As an example, if a portfolio loses 50 per cent one year, getting back to breakeven entails returning 100 per cent the following year. So the best investors never allow themselves to get into such a position. To use an American sports metaphor, a team’s best offense is a good defence.
So how does a portfolio manager play good defence? Diversification and managing position size is a critical first step. Too often investors make oversized bets, betting too large a portion of their assets on a single investment idea. A classic example is Amaranth Advisors, a $9 billion US-based multi-strategy fund that lost $6.5 billion in 2006 and subsequently failed, as a result of a huge bad bet on the direction of natural gas prices. Their positions were so large they were said to be holding up to 65 per cent of the winter’s supply of natural gas futures. Amaranth also used significant leverage to multiply their exposure many times over. Leverage or gearing often comes from the use of derivatives which are financial instruments which magnify investment returns. Borrowing cash to buy stocks in a margin account can lead to the forced liquidation of good stock positions during market corrections. The use of excessive leverage is one of the most cited causes of financial ruin for both institutional and retail investors. Taking a disciplined approach to limiting the use of excessive leverage is an essential element to the risk management process.
Too many investors lose sight of the benefits of limiting exposure to any one security or asset class. Modern portfolio theory suggests investor returns can be enhanced by holding a portfolio of diversified assets with different levels of risk and correlations. Seasoned investors, for example, will limit their portfolio’s exposure to a particular security, assets class, country, geographic region, industry sector, or currency. Many of us have gotten into financial trouble not necessarily because we bought the wrong investment but because we bought too much of it.
Accepting the inevitable loss can be so emotionally debilitating that psychologists have come up with a term to define it
Imagine Investor A and Investor B, both having an investment portfolio worth €10,000 and both buying XYZ Limited. Let’s say, Investor A, foolishly places all his cash into XYZ, yet Investor B puts just five per cent or €500 into it. Next day, XYZ announces very bad news and the share price plunges 50 per cent. Investor A anxiously loses half his account value, whereas Investor B calmly loses a meagre 2.5 per cent. Although both investors owned the same investment, Investor B mitigated the sell-off’s pain by not owning too much of it.
Getting acclimatised to accepting and taking losses by not personalising them is another trait of top investors. Sound risk management is about limiting the size of losses to a predetermined percentage of one’s portfolio. If losses exceed a predetermined limit, losing trades should be exited, without emotion, afterthought, or doubt. Accepting the inevitable loss can be so emotionally debilitating that psychologists have come up with a term to define it. “Loss aversion” is a destructive emotional bias which limits our ability to accept and realise losses. The key is to accept losses still small and manageable enough to not devastate your portfolio.
Risk management entails identifying and managing many known risks and also making provisions for the myriad unknown ones. There are many varieties of risks which can decimate returns including interest rate, currency, concentration, credit, market, liquidity, political and counterparty, to name a few. Although risk management can get complex, the use of basic common sense along with managing position size, leverage, diversification and accepting manageable losses are all very essential tools in your quest to manage risk.
This is the sixth in a 10-part investor education series which is appearing every fortnight.
Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He also is a lecturer at the University of Malta and Institute of Investment Analysis.