FMD Capital Management

3 Tenets Of Sound Risk Management Revisited

Written by Michael Fabian, April 23rd, 2013

As we have recently been served our first taste of real volatility in months as measured by the iPath S&P500 Short Term Volatility Index ETN (VXX) and SPDR Gold Trust (GLD), I find myself looking deeper and deeper into our client’s holdings to evaluate and prognosticate any potential weaknesses. Investors concerned with the preservation of their gains, as well as capital would be prudent to engage in the same exercise. With so many market participants “Whistling Dixie” in the current environment, I hold firm to the belief that hope is not a viable investment strategy. A fundamental tenet of our firm is that risk within any investment should be identified and planned for well in advance of any purchases. Its this type of basic understanding that will segue into successful changes to your portfolio down the line. Once you have the risks understood, the next step is developing a plan of action, or management if all or one of the terrifying possibilities become realities. Since managing risk starts with taking a proactive approach to making changes to your portfolio in response to a high probability outcome. As an investor, if more questions than answers arise from the mere thought of managing the risk in your portfolio, I may have some options for you.

Option 1: Hedging your bets…

The often touted and bragged about, but rarely executed successfully, hedge technique. This often complex strategy involves teaming investment holdings together that have an opposite effect on each other in an effort to net out or reduce a negative impact. For a typical portfolio that has a large amount of equity exposure, an example might include adding a fund like the ProShares Short S&P 500 ETF (SH) or the Ranger Equity Bear fund (HDGE). The pros to this type of strategy is that if you are able to time it right, you can recapture your unrealized drawdown in the way of gains by selling the ETF once its reached a point where your comfortable returning to your net long position. Another benefit would be that it allows you to keep highly appreciated positions in force without generating costly capital gains.

Before you get excited, I believe the cons to this strategy are immense and that only the most sophisticated investors attempt to execute it. The crux of purchasing another holding even if its a hedge, is that you now have to manage the inherent risk in that position also. I’ve seen it countless times, even in the bond market with an ETF like the Proshares Short 20+ Year Treasury Bond ETF (TBF), or in a gold market with an ETF like the Proshares Ultrashort Gold Fund (GLL). An investors “buys and holds” a hedge with every intention to sell it at a gain, or after their hypothesis becomes reality, but their timing and discipline goes by the wayside. Typically as nervousness and anxiety sets in, you end up selling the hedge at a large loss, then curse the day you purchased it. Up until that memory fades away into the past, and you feel confident that “this time is different”. The psychology of investing can play tricks on all of us at times, but in my opinion it takes a trained mind to maintain the discipline and vigilance needed to execute a strategy like this successfully.

Option 2: Stop the bleeding…

I liken this option to a familiar feeling almost everyone has felt, purchasing a car. When you push back from the negotiation table and shake the salesman’s hand, in the back of your mind something is bothering you. Its that feeling that you could have done better, but also the reassurance that you also could have done a lot worse. That’s the way I feel about stop losses, they are there to avoid the proverbial “big loss” and as an active manager we employ this type of strategy for every position within our clients portfolios as a last resort, cut bait point to stop the bleeding. However, setting stop losses isn’t as simple as it might seem, it is an art form. A stop loss should not be a mere price or percentage below your cost, but a dynamic strategy that should change almost as much as the underlying position does.

When examining your positions in detail, and formulating a game plan to set a stop loss, always examine and apply technical analysis to the price chart of the holding in question. This will enable you to give the position “one last chance” to change course before the stop is triggered. Looking at the chart of the GLD below, a recent hypothetical example of an intuitive place to initiate a stop loss would be evidenced by the last two times GLD tested the 150-152.50 area in Dec. 2011, and May 2012 time frames.

I would have placed the stop at 148 since the position would have reversed course by now if it weren’t at risk of an intermediate term breakdown. Now even though you wouldn’t have avoided the 4-5% drawdown on April 12th 2013, you would have sidestepped the 9% continuation move on April 15th. Hence the feeling it could have been better, but it could have been a whole lot worse! This is just one example, and it can get a whole lot more complicated than this, but the basis of this tenet is that your better off with some protection than none at all.

Option 3: Lost opportunity or lost money?

My grandfather used to tell me that lost opportunity is a much better feeling than lost money. In real world practice however, they both can feel like the great equalizer. Which brings me to the last tenet I wanted to mention, selling for the safety of cash. In today’s zero interest rate, ever inflationary world, cash is the most consistently underrated and chastised of all risk management tools. Making it a favorite of mine that I don’t see changing anytime soon. Like the two other risk management tenets explained above, cash is a strategy as well, but also one that should be carefully thought out. The size, length of ownership, and plan for cash should all be taken into account. In the past, I have even gone so far as to set stop losses for my cash position, where I would “stop in” to a given market after having to large, or to long a presence there.

Developing your strategy for cash should include a couple of different perspectives, or ways of looking at your portfolio and goals. For example, the simplest of all would be evaluating a price target for a position, then simply reducing the holding for the safety of cash once the target was met. That way, your selling on your own terms, not when the market decides to force your hand. Another example could include expanding your cash position when you meet a predetermined growth goal in a single year, or even single quarter, as to simply reduce your risk. There is not one single correct answer for everyone regarding their own personal use of cash or the strategy they develop around it. The one single thing I would encourage is that you adhere to the plan you construct for your portfolio, and not let the feeling of angst feed into poor decision making that can compound the feeling of loss. After all, opportunity is born every single day, and consequently money is lost everyday. Of the three tenets I’ve listed not one is a fool proof way to sidestep risk, but they can be sound principles to simply reduce it.