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Understanding Risk-Preparing For The Unseen

Money can’t be made without taking risk.  Risk management is not a process to eliminate risk.  Instead, the goal of managing or controlling risk is to ensure that enough reward is generated relative to the risk taken.  It is important to focus on identifying potential sources of risk, understanding those sources and then making proactive decisions as to which risks to take as well as which risks to minimize.  Risk is a problem when it is unintentionally taken on, misunderstood and/or under or uncompensated for the risk accepted.

 

The unforeseen does occur and once-in-a-lifetime events that occur every few years have become the norm.  Some examples include:

 

  • From 1992 through 2001 – A ten standard deviation event occurs every year in at least one financial market
  • 1994 – The Fed raises interest rates seven times for a total of 3.50%
  • 1995 – The Mexican Currency Crisis occurs
  • 1997/1998 – The Asian Contagion – (Emerging Stock Markets fall -57.18%.  This was started by Thailand devaluing the Baht and causing an economic meltdown of East Asian emerging market countries which eventually spread to the United States and forced the Fed to lower interest rates.)
  • 1998 – Long-Term Capital – the hedge fund, almost melts down the world’s financial markets
  • 2000 to 2002 – The S&P 500 falls 44.70% from peak to trough.  The NASDAQ composite falls 75.03%
  • 2001 – September 11th
  • 2002 – Widespread corporate scandals
  • 2003 – The mutual fund scandals and the Iraq War

 

What can be done to minimize these risks to avoid portfolio losses?

 

  1. Stress testing portfolios by considering the unthinkable.

 

  1. Build a portfolio with investments that have low correlation with one another.  Although correlations go out the window in times of crisis in the short run, they do work well, usually in a period as little as a few months.

 

  1. Avoid the same mutual fund “familyitis.”  No fund family alone offers good or great diversification options (funds) within the fund family that have low correlation with each other.

 

  1. Hire portfolio managers that have maximum flexibility in what they invest in and who don’t override their own security selection discipline.

 

  1. Forget the four corners approach – in other words, style box investing – if all of the monies in a portfolio are going to be in U.S. securities only.  Virtually all domestic equities have high correlations with one another.

 

  1. Always continue to perform due diligence on an ongoing basis.  In short, keep asking questions.  Talk with portfolio managers of each fund that is being utilized or researched, read articles and research materials about a fund as well as the fund’s prospectus and the Statement of Additional Information.

 

  1. Avoid portfolio managers with too much money relative to the asset class they are in.  They can’t sell quickly enough to adjust their portfolios.  Listed below are a few (although somewhat arguable) criteria for maximum asset sizes of equity asset classes:

 

U.S. Micro-Cap Funds                            $200 million

U.S. Small-Cap Funds                            $500 million

U.S. Mid-Cap Funds                               $1.5 billion

U.S. Large-Cap Funds                            $5.0 billion

Hedge Type Funds                                 $500 million

REIT Funds                                           $500 million

Emerging Market Funds                         $500 million

International Small-Cap Funds                 $500 million

International Large-Cap Funds                 $5.0 billion

 

  1. Make sure the fees a portfolio manager is paid are justified by the risk-adjusted returns received as well as the services provided.

 

  1. Always invest with risk management in mind – not only from a negative return standpoint, but relative to inflation, after-tax returns, liquidity and how the advisor counseling the client will be perceived from a client’s standpoint.  Avoid fund groups with a checkered history from a regulatory standpoint or that offer an unsustainable recent track record.  A blow-up or substantial loss is just around the corner.  A long, uncomfortable explanation to clients will undoubtedly accompany it.

 

  1. Evaluate investment and economic assumptions continuously.

 

  1. Follow the legends of investing – people like Warren Buffett, Jeremy Grantham, Steven Leuthold, Robert Arnott, Bill Gross, Cliff Asness, Jean Marie Eveillard, Robert Rodriguez, etc.  These individuals may miss the short term move, but they almost always have the big picture correct.

 

  1. Hire portfolio managers that have substantial portions of their own net worth invested in the fund they manage.

 

Make sure the unforeseen is foreseen.



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