A Guide To Managing Risk

Includes: AIG, BAC, JPM, KO, MS
by: The Keating Letter

A few weeks ago I was lucky enough to be a guest lecturer at a securities analysis class for George Washington University. The class manages a portion of the endowment, so it's a great hands-on way for undergrads to learn about investing. Instead of classes like this when I was an undergrad, I had a class on courtship and marriage. That worked out well, though, since I've been happily married for five years. My wife had a bowling class in college.

Scholastic focus seems to have improved. What hasn't, though, is a focus by investment firms on risk management. I looked through the resume of the students, and they were impressive. Many of them had had summer jobs at firms including Merrill Lynch (NYSE:BAC) and Morgan Stanley (NYSE:MS), as well as other, smaller firms. I asked if any of the students had been trained on risk management by the firms they worked at. They hadn't.

This is both a good and bad thing. Certainly it's bad that Wall Street firms don't seem to care enough about risk management to at least give their summer associates and interns at least a cursory course on the subject. Even if these students don't have positions where they have any authority, a focus on risk, or even a cursory review, would demonstrate to them that it's important to the firm.

So, that's the bad part. The good part is that when I presented my views on risk, they didn't conflict with anything the students had already learned. I have no doubt that my views would have contradicted what Merrill Lynch would have taught.

There are four important ways to control risk as an investor. I encourage you to always remember them:

  1. Limit leverage: Leverage is one of the few ways you can be correct on the investment or trade, but still blow your portfolio up. It was recently announced that Maiden Lane II is being fully liquidated at a profit. The NY Fed started this fund during the crisis to manage some of AIG's (NYSE:AIG) most toxic holdings. After the final liquidation, the NY Fed will end up with a substantial profit. The same thing is holding true for Maiden Lane III (containing more AIG bailout assets) and Maiden Lane I, which holds junk from Bear Stearns' failure that JPMorgan (NYSE:JPM) refused to take. If these ultimately were profitable trades, why the bailout? Collateral requirements from the leverage used by Bear Stearns and AIG to make these trades killed the firms. There's never a reason to risk your portfolio by over-leveraging. Margin calls come at the worst time.
  2. Know the company very well: Charlie Munger advises investors to always invert. That means you should come up with reasons why your thesis is wrong. If you like a company, figure out what could occur that would cause it to fail. You may think you already know a company very well, but you should also stress test it in that way. Black swans seem to be much more common than we think. The better you know the company, and the more potential challenges you can come up with and the expected response from the company will help you choose investments that can withstand adversity.
  3. Have a large margin of safety: Volatility, as measured by beta, isn't risk. Coke's (NYSE:KO) beta for the last 10 years is something like 0.4, but look at its chart. It saw fluctuations as much as 50% on occasion, both up and down, and in a relatively short amount of time. However, its earnings only decreased twice in the past 10 years, and only once significantly. The risk was owning it at the peak. By only buying into a stock when there is a large margin of safety, risk is significantly decreased. Coke is relatively simple because of its cash flow and earnings stability. Most stocks aren't very simple at all, but there's no shame in taking a pass when unpredictability is too high.
  4. Your temperament is the best risk control: Your temperament may be the most important risk control there is. Few MBA courses will teach this because it's tough to measure. Without mental stability, you wouldn't appreciate the three factors above. Jon Corzine wouldn't have cared about those factors because he was a risk taker. Aubrey McClendon doesn't care. The Long Term Capital Management guys didn't care. I'd rather have my money with someone who knows he's infallible and worries about the downside. You should too. It'll help you sleep at night.

The students in the security analysis class actually have it harder than most. They're smart. Really smart. That's a problem. Hubris is dangerous, and makes you fail to appreciate potential problems.

Successful investing requires a unique combination of confidence and humility. You're making a decision based on your confidence of knowing something others don't. You have to be self-assured enough to pull the trigger. At the same time, you always have to consider whether the rest of the market is right, and it's you that's wrong. That's not easy. Even harder is trying to balance the two and not allowing your confidence or your humility to overtake the other.

My advice is to forget about things like beta, and focus on these four risk control measures. And, because you are the easiest one to fool, review them often.

Disclosure: I am long BAC.