Everyone is focused on the human tragedy in Japan. Hopes and prayers of all go out to those stricken. In such an environment it can be difficult to think about business and what the effects will be. Nonetheless, that is the job of the investment manager. We need to put emotion aside and think clearly about the issues.
Everyone needs a strategy for dealing with risk. It must be planned in advance. As he does so often, Barry Ritholtz has the colorful quote on the subject:
The time to look for the emergency aisles and where the exits are located is before takeoff, not after the wings fall off the plane. You must have a plan in place to deal with unanticipated events, a just-in-case things head south scenario.
Exactly. We all need to plan ahead.
I am going to explain my own approach. Feel free to agree with whatever portion you find useful.
Let us start with what not to do. I do not approach investment with a single "fund" that is either in the market or out. I have several different programs, blended to individual needs.
In particular, I reject the idea that you should reduce stock exposure because of some rhetorical or political arguments about the market. It is better to rely on a data-based system (described here). (I also offered readers my recent report, Limiting Risk. Just write to falin at newarc dot com). Most investors, and even many pros, are overwhelmed by emotion. Bad move. The alternative?
- Try to measure the impact of the crisis. Thinking about quantification forces objective reasoning and displaces emotion.
If you have a plan, developed in advance, you will be prepared for a crisis. Otherwise, emotions will prevail.
The most important element of our approach is to maintain confidence by limiting risk. For an investor to stay the course is a tricky problem. Everyone would like to have a system that had a short-term, top-calling orientation in market rallies. Does anyone really get this right? Most of the top-callers have been out of the market since September. And those are the good ones!
We have three elements of risk control.
- We have a dynamic asset allocation (DAA) program that relies strictly upon the data. This program treats the first 10% or so as noise, but it is always on the right side of major moves. It goes short in a 2008-style situation.
- We use the St. Louis Fed Stress Indicator. Instead of listing worries, we measure them. The SFLSI gave a great warning in 2008. This warning is not anticipatory, but reactive.
- We use professional analysis. I watch all of the news all of the time. If there is something specific that is not reflected in our quantitative methods, I can act independently.
Let me take a closer look at that last point, the human part of management.
What I Do
When I am dealing with a crisis situation I approach the problem on three levels -- worst case, macro, and stock specific. In the current situation I have spent many hours on the research, following stories as they have appeared around the clock, beginning in the early hours of the morning. When markets are moving, the investment manager must attend to clients rather than write. Having said this, here are a few thoughts.
- Worst case. We are all trying to get a read on this. When there was a sense that there might be a nuclear meltdown, the market was at the low point. As Josh Brown notes, the tendency is to overreact. The reason was that there was no good way of quantifying the impact. Various sources noted that there was no precedent, no model, for a meltdown in a populated area. When the news changed for the better, the market rallied sharply.
My conclusion: As long as the nuclear consequences avoid a meltdown (more Three Mile Island than Chernobyl) we can analyze the crisis with "normal" methods. Reaction by floor traders seemed to support this conclusion.
- Macro. Everyone was trying to determine the economic effects and the global economy. While these were just educated guesses, there were some good articles.
My conclusion: The immediate GDP effect on Japan and on the world economy is likely to be minimal. This piece at Econbrowser was typical of several that seemed to be the most authoritative. The mixture of pluses and minuses in the actual GDP tally seems counter-intutive to some, so I urge you to read the article. The long-term debt consequences could be different. Here is another good example.
- Stock Specific. Careful thinking each of your individual holdings is important. Some of our stocks have done quite well (construction, health care, some energy) while others have been under pressure. One question relates to Japan's role in the supply chain. This may be especially important for some technology companies.
My conclusion: I am reviewing stocks like Apple (AAPL), where products include parts from many companies. A single component in short supply could hurt sales. I am looking more favorably on companies that will be part of any reconstruction effort (CAT).
The result of the various conclusions has been moderate buying after the Fed announcement on Tuesday. The macro risk indicators have not triggered.
The Real Test for Investors
This type of crisis provides a good test for the individual investor. The actual market reaction has -- so far -- not been very significant. It is not really a test of courage or risk tolerance. If it seems so to you, I recommend one of the following steps
- Reduce stock exposure and add bonds to lower portfolio drawdowns. It is important to invest at a level that is comfortable. Drawdowns of 10-15% are an expected part of the trading year for stocks. Accepting this level of risk is part of gaining superior performance.
- Don't watch the news! Or at least don't think about stocks while watching. Leave the worry to someone else if you want to get personally involved.
The famous investment gurus always advise being fearful when others are greedy and vice versa. This attitude is easier to talk about than to implement in practice, especially with a constant flow of scary images on TV.
The secret sauce in our risk control measures is not what they save in down markets. It comes from the confidence to stay involved in up markets.