Effectively Managing Risk in Today’s Stock Markets

Risk management with investments

Investors often worry about risk, but many don’t think about it too much unless they have already been exposed to a lot of it. We always want to be aware of such things.

A very popular approach to risk management among individual investors is to just choose to ignore it, and even approach this ignorance as a badge of courage or resolve. Perhaps people they know got out of the market when things turned real sour, but they had the good sense to ride up the storm. Here we are, 10 years later, and who is laughing now?

It doesn’t matter how flawed this thinking may be, because that’s how they told us to do it and they told us this was the right way, and we’re following it come hell or high water. Sometimes the water actually does get too high for some people, and they end up bailing after getting creamed, but we’re not weak like that and have the results to prove the wisdom of our approach.

If we’re going to go down this path, we at least need to be in a position to rationally assess the merit of this sort of plan, and the fact that we’re told by a lot of people to invest this way doesn’t count.

This is in a sense risk management, but one where we’ve decided any amount of risk is acceptable. It might be acceptable on a subjective level, in other words we know the risks and are prepared to bear them, but that in itself doesn’t mean anything. This would be like a gambler happy to risk his whole paycheck every week at the slots, meaning we might be comfortable but not very wise.

There are investors on the other end of the scale who do not even seem to have the minimum risk tolerance to invest properly, as you do have to take on a certain amount and be comfortable with it. Contrary to what many may think, the longer your investment horizon, the greater the risk, and investing requires a certain minimum time horizon, usually a couple of years or longer.

This doesn’t mean that we need to stay in an investment for that long, but rather, we expect to unless something comes up that makes this unwise or undesirable. A good example would be investing in 2007 before the market started to crash, seeing the decline and all the gloom and doom on the street, and deciding to get out to avoid the mess that pretty much everyone knew was coming.

We Need the Right Amount and Kind of Risk Management

Investors that sweat the market every day are among those of longer timeframes, and if investing in stocks causes this much stress and grief and daily deliberations or even daily attention, the investor may be better off putting their money into something less risky, or learn to trade in shorter timeframes that are more suitable to their level of concern and attention.

With risk management, we don’t want too little or too much of this, but the right amount, or at least something close to it. You might be able to keep throwing your money at the stock market and keep it there with no regard to what may be going on, but given that we will all admit that the goal of this is to seek out returns, we really do need to be using returns as a yardstick here.

The first step to approaching investing this way is to realize that it’s not always OK to ride out the big bumps and crashes just because they always have come back. Perhaps this will take a lot longer than you may think, and you’ll need the money before you can wait to overcome these losses. That’s not the main reason why this isn’t a good idea though.

When we lose money in a position where we could have been out of it, while we may make it back, the money that we make back could actually add to our overall return instead of making up for losses. If we lose 20% and then gain back 20%, this is a net gain of zero. Timing this won’t get us a pure gain of 20%, because this would involve timing the trends perfectly, but if we can get 10% or 15% net out of all this, this is our advantage over those who just stand in the field like a scarecrow and hope too many birds don’t come around.

What’s lost is in fact lost forever in a very real sense, because you are always faced with the obstacle of making it all back before you even get even from these moves. It also takes a bigger gain to make back a loss of a given magnitude, and the bigger the losses, the bigger the difference here.

If you lose 25%, you now have to put in a gain of 33% to get it back. If it’s 50%, you need a 100% return to get even. This is actually one of the biggest reasons why you want to weigh losses more than gains, dollar for dollar, and sacrifice a certain gain to prevent an even bigger loss.

We don’t want to do too much of this though, and especially do it at the wrong times, especially during bull markets. If we had set aside half of our money over the last 10 years, where the market returned 300%, we might be happy with a 150% gain or 15% per year, but we need to make sure we got our money’s worth in risk management for holding back half our money and missing out with it.

Over the last 10 years, there really hasn’t been much of a reason to do this, because the market has been going up all this time overall. The 150% gain we gave up was pretty much wasted. This is not a good example at all of proper risk management with investing, and may not even be as good as what the do-nothing crowd does.

The reason for this is because markets go up more than they go down, and if you stay in things, you gain more from being in when things are running good than lose when things are running bad. Fixed hedging like this is arguably the worst approach to investing, even though it is widely promoted and used. As long as one can bear the risk, just holding will provide significantly better returns overall.

This does not mean that just ignoring risk is a good idea, it’s just a little better than a fixed hedge generally, but not by that much. Both approaches expose us to the maximum amount of risk in the market, we’re just not doing it with all of our money by holding it back. Holding back therefore does hedge more than no hedge at all, but there’s the other side of the coin to be accounted for as well, the effect upon return, and this is where fixed hedging gives it up.

We still want to try to manage this, but in a way that is actually sensible. Realizing that large position losses involves money that permanently and not just temporarily lost is a great start to looking to manage our portfolios more effectively.

We Waste a Lot of Time Recouping Unnecessary Amounts of Losses

There’s also the matter of how long it takes to get it all back, and Beaumont Capital Management has taken the time to calculate these things. They found that the average return in bull markets is 17%, and just from that one statistic, we can calculate how long it will probably take us on average to overcome various percentage losses.

They provide the examples of a 20% loss, such as the one we saw late last year, that would take 17 months to recover from, with a 50% loss taking 50 months typically. We actually only took less than 4 months to do it this time, but it doesn’t always work like this, although this does give us some more insight into just how strong this recovery has been.

Beaumont points out that “if you combine the amount of time where your portfolio would have started losing money with the time of the recovery, you are talking about years of no-growth.”

The rub with this is that we can’t just use anytime our portfolio loses money as the signal to exit, and we have to actually build in some real room between when we started losing and when we have lost enough. This is where the challenge lies.

If you set a 20% moving stop during last year’s dip for instance, you would have exited at the exact wrong time, bearing the full loss and missing out on at least some of the recovery, depending on when you re-entered.

This will take a plan, and a good plan, and does require some effort an attention, although not a lot, but those investors who don’t really want to do anything are probably better off just doing that, as to do this right does require a commitment and a real desire to help your portfolio.

This is not something that your advisor will just hand you. This is truly a game of skill, although even the most modest skill tends to get rewarded, with greater skills earning more.

We should actually be a lot more motivated to participate in our investing success than we tend to, given how important the end game is here, which is our well-being in retirement. It is not really that difficult at all to avoid the big stuff, and we really haven’t seen much of that since 2009, and staying in all this time wasn’t a bad idea at all. Steering clear of the real thing in 2007-09 wasn’t that difficult though, when even your kids probably knew that this was not a good time to be long stocks.

The results do vary, quite a bit actually, with those who take this road, but this also serves as an incentive to improve and to assist yourself even more. There is a lot on the line here, and caution should certainly be well used, and part of the goal here is to actually be more cautious then Joe Investor is. The real goal is to both reduce risk and improve returns, to be around when it’s good to be around and not be when it isn’t. This is the proper goal of investing in a nutshell actually.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.