3 Tenets of Successful Risk Management
During long up-trends in the stock market, most advisers rarely concern themselves with what their exit strategy would be if things do not go as planned. At FMD Capital Management, we find ourselves looking deeper into our client’s holdings to evaluate and prognosticate any potential weaknesses. Stock market investors should be concerned with the preservation of their gains, and prudence suggests making changes when volatility is low and liquidity is abundant. With so many market participants “Whistling Dixie” during a bull market environment, we 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. It’s this type of strategic planning that will segue into successful changes to your portfolio as part of our active management philosophy. The strategies below outline the tools we employ to protect our client’s capital.
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. It’s 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 we feel about a sell discipline, they are there to avoid the proverbial “big loss”, and as an active manager we employ this type of strategy for key positions within our client’s portfolios as a cut bait point to stop the bleeding.
However, setting a sell discipline isn’t as simple as it might seem. It is truly an art form. A sell discipline should not be a mere price or percentage below your cost, but a dynamic strategy that can change with market conditions. When formulating a game plan for this method, we always examine and apply technical analysis based on the price chart. This enables us to objectively monitor each holding on a daily basis and apply our sell discipline when needed.
Using Cash As An Asset
Dick Fabian (our grandfather) used to say that “lost opportunity is a much better feeling than lost money”. In real world practice however, they can both feel very disconcerting. As a result, we have developed a simple axiom at our firm to use cash as an asset.
In today’s zero interest rate, ever inflationary world, cash is the most consistently under-rated and chastised of all risk management tools. This mere fact makes cash and short-term bonds a preferred method to anchor our portfolio when conditions are less than ideal.
Developing our strategy for cash includes examining our client’s goals and objectives alongside the potential risks that lurk in the shadows of the current market environment. We may end up expanding our cash position as one of our holdings reaches a predetermined price target or deploying our cash stockpile as opportunities become more abundant.
Having some measure of cash on hand gives us more flexibility to weather volatility and take advantage of circumstances that other investors may be unable to access.
Hedging Your Exposure
This often complex strategy involves teaming investment holdings together that have an opposite effect on each other in an effort to net out or mitigate a negative outcome. For a typical portfolio that has a large amount of stock exposure, an example might include adding an inverse stock fund, or pairing high quality fixed-income positions to offset the volatility. The pros to this type of strategy is that if timed correctly, it can recapture some or all of the unrealized draw down by selling the hedge once it’s reached a point of capitulation. Another benefit would be that it allows us to keep highly appreciated positions in place without generating costly capital gains for taxable accounts.
The crux of purchasing another holding, even if it’s a hedge, is that you now have to manage the inherent risk in both positions. We have witnessed countless tales from individual investor’s, where a hedge is “bought and held” with every intention to sell at a gain. However, their timing and discipline goes by the wayside, and the benefits quickly evaporate through waiting and watching.
In our opinion it takes a disciplined mind to maintain the vigilance needed to execute a strategy like this successfully. At FMD Capital Management, we only implement hedges in very specialized situations and monitor them daily.