A REAL-TIME LOOK AT RISK MANAGEMENT
On December 2nd I wrote a piece entitled “Gold represents the massive risks in this market“. I wrote that gold had come to epitomize the reflation trade and the herding of investors into all risk assets. The yellow metal had gone parabolic and I declared that it was looking bubbly. You can only imagine how unpopular this outlook was with the vast hordes of investors who had piled into gold over the last few weeks. My email inbox was flooded with angry investors who viewed my call as a personal insult. It was the farthest thing from that. Rather, it was nothing more than a risk management call. I have no position and had no position in gold, but from a risk management perspective it looked like an incredibly risky asset to be toying around with (bear in mind, this was when gold was trading 8% higher than it is today). I made no money on the call. It was by no means a great call. It was a nothing call so please don’t view this as me tooting my own horn. But from a risk management perspective, the idea that you should simply avoid gold at all measures was the right call.
I am a firm believer that risk management separates good investors from bad investors. Anyone can ride a trend or run your standard 90% long equity mutual fund, but where does the alpha come from in these portfolios? Real alpha comes from superb risk management. And in most cases this is knowing how to avoid the steepest losses.
The arithmetic behind declines is quite simple. If you lost 50% of your portfolio last year (as most investors did) you now require a full 100% gain just to get back to even (staggering isn’t it?). So even if you remained fully invested throughout the recent downturn (where you lost 50% and then made 60%) you are still down 20% from your starting point.
The point here is that sometimes the best move is not long or short, but rather no position. Like a good poker player, the best investors only make bets when the odds are in their favor and avoid playing when the odds appear stacked against them. Feeling like you always need to be involved in the market is the wrong approach. Rather, knowing how to avoid the landmines is the best path to success.
It would have been a good call to just short.
I disagree. I think this was a great call. Not because you knew something about what was going to happen, but because you didn’t know. One thing I have learned from reading this site is that inaction is sometimes the best action. We don’t know everything about the markets and sometimes playing the humble role of the unknowing investor is better than the unknowing lamb to the slaughter.
Whether to be long or short the market or have no position at all in equities (or gold) is an asset allocation decision. Deciding to trade or invest with a longer time horizon or both simultaneously is a strategic decision.
I agree that risk management and the avoidance of large losses is key. But putting all your eggs in one basket (be it equities or gold or treasuries or cash) is inherently risky. It can pay off big in the short run if you are right (or lucky) but in the long run maintaining a diversified portfolio while varying the allocation based on risks and potential returns is probably a less risky and considerably less stressful approach than timing the market by jumping entirely in and out of specific assets or asset classes.
Rob, what convinces you that buy and hold will continue to work going forward?
Buy and hold and forget and never rebalance was never a optimal strategy. But buy and hold and rebalance may very well be a viable strategy over the long-term.
It all depends on at what you buy and at what price you buy.
The best time to buy stocks is usually when it appears to be risky to hold stocks. Stocks looked like a horrible investment in 1980 after a decade of going nowhere. Stocks look like a lousy investment now after a decade of going nowhere. Nevertheless, relative to other investments stocks look better today than at just about any time since the mid 1990s. They sure looked better in March and maybe we get another crash over the next few years that makes them even more attractive. I would like to see the S&P500 at 550 or so.
Ultimately you have to hold something. (Holding all cash is an asset allocation decision). My point is simply that holding any SINGLE asset including cash (US dollars or any other single currency) is risky. (The specific risks vary by asset and some offset others). Holding a diversified portfolio and modifying the allocation targets based on economic and market conditions is probably less risky then trying to time the market buy going all in and all out.
Will stocks go up or down next year? (Next month, next week, tomorrow?) I don’t know. Will the next earnings season result in another leg up or a sell-off? I don’t know. Has gold peaked? I don’t know. Is inflation or deflation the bigger threat over the next decade? Will the dollar collapse or rally? Will Japan sink under the weight of its debt and aging population? Will emerging markets skyrocket into a bubble or collapse or both? Will oil prices be $40 or $100 a barrel next year?
I think stocks will probably be both 10% higher and 20% lower at some time during the next year. I have no idea which will come first. (Most think an early year rally and a late year sell off. Maybe exactly the opposite happens.) I think stocks are fall less overvalued than gold. I think gold is way overvalued but may spike to hit $1,500, but I wouldn’t bet on it. I think deflationary forces of declining credit will probably hold inflation in check. I bet that the dollar rallies against all odds and asset prices collapse again sometime between now and 2012, but would I buy treasuries now, no. I bet oil prices fall unexpectedly.
You can place your bet on any scenario and it could be right or wrong. If you are right, is it luck or special knowledge? If you think you really know something others don’t then you run the risk of deluding yourself that it is skill rather than luck if you are right a few times.
Would you have been better off buying in March and holding until now or buying and selling? Which is really riskier?