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Manage Risk & Protect Returns


One can't manage risk without admitting it exists.

Viewing the forest through the trees is not easy or short term profitable.

Keeping an eye on where we are in the business and credit cycle makes common sense and therefore good business sense.

Over the past ten years or so of occassionaly bloviating about markets, I have discovered a few things.

Number one, when you write a thesis that is counter to the market narrative of the day, you should rightfully expect backlash and nasty commentary which is counter to the confidence narrative that creates new wealth. Being contrarian is fine, but when you are wrong you are usually more/extra wrong and being wrong publicly is never fun. Which is why I like stops and option spreads.

Number two, market risk is still not a risk worth managing for most people, and some have made an enormous fortune using just a benchmarking technique long only to pay the bills. This has worked really well for a really long time. Can it continue indefinitely is the question I think everyone involved wants answered, and the answer is too hard to know. My view is that pigs get slaughtered and eventually bull markes end.

When in place, games like currency wars and HFT chicken can lead to the Quant Quake set ups of last week. Guys were short things that looked cheap/low vol and long the expensive things. Performance chasing also leads  into closet indexing which has worked really well at least up to now. While I'm stating the obvious, the few value investors and hedge fund managers left who actively and actually manage downside risk will almost always underperform in wildly speculative bull market runs.

The best way to play it over the past decade was to invest like Richard Driehaus who's strategy is to be such an outlier to the upside that it sort of balances out the downside over time. Investing with Warren Buffett's Berkshire Hathaway (BRK.A) was actually less risky than the index fund in many ways due to his focus on value, yet he even admits that he expects to underperform in long straight up bull runs and to outperform during panics and bear markets. 

Because of the huge run-up in equities since the GFC, "risk management" is a dirty term but that's as it should be given the monetary and fiscal policy regime over the last ten years. Indexing is about throwing out one set of risks to embrace market risk alone, which over the very long haul will probably pay off.

It's just that there are severe drawdowns along the way. I'm usually long the market, but I want to find ways to avoid the severe drawdowns too. The index strategy works because many investors and managers are too conservative over a full cycle, considering the Dollar loses 2-3% per year on average and the level of GDP growth coming in at around 2% being too conservative is a big risk and one with which I am personally familiar.

An index fund captures almost all of the upside that a manager can produce, if not more, regardless of whether or not a manager is intelligent enough to sell it all before a massive decline. The risk with indexing at this stage is that you wont sell before the big crash, if it ever happens. That's the most obvious risk in a world of obvious risk.

So the conclusion is wait for a big drop and sell some put spreads on the index, but don't catch a falling knife. Wait for some blood to flow first. But until then stay diversified and stay hedged if your risk tolerance is low. It never hurts to think.

One tricky part in markets and investing are the hard times. Things don't always work out, and as Roy Neuberger once said "Wall Street can be a cruel place." Hard to unlearn lessons of the past. Things that remind us of our collective past. Times we haven't seen since 2008. Sure, the mini-bear of 2011 and the December to remember sales event of 2018 were scary and remind us of those times, but each was quickly and violently reversed by hand holding governments and corporate share buybacks using debt.

While I'm not knocking indexing as a strategy per se, some very notable value investors such as Michael Burry have explained that systemic and systematic market risk could be the next sub prime. When retirees eventually decide to cash out, things could finally turn dicey for teflon high flying U.S. equities. That's a scary thought, but one that investors should contemplate with regards to their weighting of equities in a portfolio. There is price risk and even some credit risk this time around. 

What the quant quake, the repo madness (repo rates rose from 2.25% to 10% this week) and last December show us is that risk is potentially more real than perceived at current valuations. Nothing cures valuation bubbles and inequality issues like a good old fashioned bear market. Bear markets are scary -- people by definition lose a lot of money and that's traumatic. However, nobody cries for you and your paper losses.

Is a bear market FINALLY going to come? No one knows for sure, but you cannot manage the index. You can not manage the amount of money the market owes you. You can only manage your risk at a time like this and I'm not even the guy to tell you how to do it. All I know is what I see. So a 50/50 is probably enough depending on your age and risk tolerance level. It's the other 50 that is equally tough. On that, I would be concerned about credit risk but also duration risk. But hey for me personally its harder assets and things I can't lose on a trade that I am mainly long or whatever. Stocks are good but at the wrong times in history can be a bust.

Of course, selling and raising cash creates issues (just look at repo rates!) too. Should you own T bills (VMMXX)(TLT)? Should you own money market funds? Should you be short the market against your long book via in the money leap put options or bear call spreads? Is now a good time to own gold (PHYS) and silver (PSLV)? What about owning a few mining stocks like (NEM), (FCX), and (NYSE:AU)?

I do think the answer to the above questions is a resounding "yes" but I caveat that by saying that good cash flow positive real estate investing makes sense too, especially if done without too much leverage. I like T bills but I do worry about the debt clock sometimes as well.

All in all, our allocation targets are still around 30% US equity, 20% T bills, 20% foreign, 10% metals, 10% real estate, 10% timber with some puts (1% in leap put options) or some shorts for some shorter term trading profits or as a hedge.

Writing calls against longs you would sell at a higher price can work. In an IRA, covered calls are smarter in my opinion than actually owning stocks. Try covered calls with the addition of a put option that expires several months out at a strike low enough that you would like to be stopped out but high enough that the name might actually hit your strike. Options are a tricky game, but for retirees, it would be worth the time to learn about strategies to reduce risk or gain income or both.  

Investors can also look for absolute return funds. There are several mutual funds that do a decent job hedging risk. Boston Partners (BPIRX), Diamond Hill, Glenmede, and other fund sponsors have offerings with good long term risk adjusted returns when added to a portfolio including equities. I still like the time tested rule of owning no more than 50% in equities if over the age of 50, but there are ways that sophisticated investors can sell options or use them as a hedge to reduce risk and or volatility or to earn income. There are also some good hedge funds around if you can stomache the ups and downs. Three HF shops that are likely poised to make money in a down market/economy are Crescat, Dunn Capital, and Horesman Capital. Could they be wrong? Yes, but because they all have good longer term track records the risk is worth the potential payoff if you are long stocks here and refusing to sell them and need a hedge. Of course, there are the issues of fees and transparency and I'm not suggesting that you actually invest in anything. I would tell you everything I own but then we don't know eachother very well, and frankly i'd be embarrassed about it. 

Selling premium vs going long is probably a great idea going forward, but use bull put spreads. Other than that, be careful and stay nimble. If the market corrects, be prepared. If the turbulence doesn't show up, that's great, collect some premium somewhere and collect some dividends and coupon payments. If you ride it out the storm will pass eventually and you will make it home. Remember, the worst thing to do is to panic and overtrade without stop loss orders in place. Remaining dry and unemotional in all investment decisions takes discipline. I know I'm definitely a work in progress, however nothing worth doing is easy or can be done on a whim. Trading is a martial art. 

Disclosure: I am/we are long PSLV, PHYS, BPIRX, BRK.A, Gold, SLV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.