Instead of Modeling Risk, Why Not Control It?

by Chuck LeBeau

Risk comes from not knowing what you’re doing.” Warren Buffett

To be more successful in helping investors the professionals that provide guidance to wealthy investors need to step up and take control of risk rather than sitting around figuring how to estimate risk using complex models and simulations. All models are necessarily based on a multitude of critical assumptions and if any of those assumptions are wrong, and a few of them always are, then the model is worthless and actually does more harm than good. It’s better to acknowledge that you don’t know the risk rather than to proceed under a false assumption.

The volatility investors faced within the equity markets in 2008 and 2009 led me to think about the changes I’ve seen as an equity trader and manager over many years.  As an investment professional for more than 45 years, believe me when I say that I have seen plenty of changes.

The basic principles of investing have remained constant throughout history. Successful investing is all about risk and reward; it always has been and always will be. If there were no reward no one would bother to invest and if we assumed there was no risk we would either be ignorant of the facts or most likely looking at some sort of Ponzi scheme.

Investing relates risk with reward and that is something you already know.  In this article I intend to deal primarily with the risk side of investing because no one has control of the reward side. However it surprises me that so little is actually known and understood about the risk side of investing.  Let’s briefly summarize a few things that we do know about the risks of investing.

Most investment professionals are aware that risk exists and spend a great deal of time and effort trying to prudently define the risk of each investment and then attempt to limit the risk to some acceptable amount that is proportional to the expected rewards. As simple as this approach might seem it quickly gets very complicated. Professionals have found that accurately quantifying and forecasting risk is surprisingly difficult. Look at all the failed models the academic community has come up with to quantify and anticipate the risks of a particular investment or a portfolio of investments.

Whenever I am thinking of examples of attempts to model and quantify risk, Long Term Capital Management comes to mind. As you may recall, some of the brightest minds in the academic community got together and came up with a plan to provide attractive returns with hardly any risk. On paper the idea looked foolproof but in reality they had no idea what was eventually going to happen. Their complex models did not correctly anticipate the eventual risk and the project blew up costing the investment community hundreds of millions of dollars in losses and requiring the federal government to take some extreme (at the time) measures to prevent a broad financial meltdown. The point here is that even the brightest Nobel laureates failed dismally at predicting and limiting risk. What they failed to understood was that the only way to predict risk is to take control of it. Why go to such great lengths to build complex models to estimate risk when we have the ability to simply set the risk at the level we want? In this article I intend to explain the advantages of simply taking control of risk rather than simply trying to estimate what it might be. I will also explain how risk can easily be limited.

To be more successful in helping investors the professionals that provide guidance to wealthy investors need to step up and take control of risk rather than sitting around figuring how to estimate risk using complex models and simulations.  All models are necessarily based on a multitude of critical assumptions and if any of those assumptions are wrong, and a few of them always are, then the model is worthless and actually does more harm than good. It’s better to acknowledge that you don’t know the risk rather than to proceed under a false assumption. Even generally reliable methods such as Monte Carlo simulations are now under attack for failing to accurately predict the probability of the 2008 decline. According to these simulations the probabilities of a decline like the one we just experienced were so remote that it wasn’t supposed to have happened.

Now let’s move forward and get right to the heart of the problem. I believe that the common investment philosophy of buy and hold is entirely to blame for the drastic losses that investors have suffered and for the current lack of confidence in equity investments. You should note that I refer to buy and hold as a philosophy and not a strategy.  That is because buy and hold is in fact the absence of an exit strategy which leaves the eventual outcome of the investment entirely to chance with no control of the risk.  If you start out with the idea that you are going to buy a stock and hold it forever regardless of what happens then it is impossible to know what the risk might be unless you assume the actual risk is the total amount invested. Unfortunately that dire assumption would be the only correct one. Any more optimistic assumption of the risk when using a buy and hold approach is flawed and likely to fail.

Now that we have accurately quantified the risk of investing in any particular stock there are many obvious problems associated with the assumption that the risk is 100% of the amount invested. In order to invest successfully we want our potential reward to exceed our risk. That principle is the foundation of modern portfolio theory. If the risk is 100% then our reward should be more than that. However, in many cases a return greater than 100% may not be possible or realistic. How many investors would enter the equity market if they were aware that their risk was 100% of their investment?

Now we can appreciate the reasoning behind the need for portfolio diversification.

I think it is safe to say that a policy of prudent diversification should prevent us from losing 100% of our total investment (as long as we are not using any form of leverage). However, as we clearly saw in 2008, diversifying a portfolio of stocks will not prevent losses of 40% or 50% or unacceptable losses that could be much higher. The clear threat of systemic risk makes portfolio diversification and periodic rebalancing ineffective in limiting risk to acceptable levels. In fact the former manager of the Harvard endowment, Mohamed El-Erian, recently stated, “Diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.”

The realization that risk is not being effectively controlled by traditional portfolio management techniques is disturbing to investors and has not only caused them to lose confidence in equity investing but in their wealth advisers as well. That current state of affairs is unfortunate because the solution is to simply abandon buy and hold and implement a strategy that protects equity investments with trailing stops.

Unfortunately however the mutual fund industry has deliberately misled the public and advisers into believing that any form of market timing will cause investors to miss important rising periods in the market and drastically reduce long term results. The dissemination of this false, misleading and inaccurate information should be a criminal offense.

The mutual fund industry and their stooges in the investment community have been very fond of publishing various studies that show the negative consequences of missing a handful of important up days in the market. They want investors to believe that they must be willing to hold on to their investments through thick and thin in order to make a decent return. They publicize misleading excerpts from academic studies to frighten investors into believing that they should never sell and reassure them that in the long run they will benefit from doing nothing to mitigate the drastic losses that they are exposed to. It would seem that because mutual funds are unable to use market timing they don’t want their investors to use it either.

Let’s talk a little about these typical studies and why they are so misleading. The studies always show the consequences of missing a few important up days in the market but fail to point out the benefits of skipping a few of the worst down days in the market. The truth is that the benefits of skipping those down days far outweigh the penalties of missing the equivalent number of up days. Let’s take a close look at what might be the most comprehensive study of this subject.

The study I will be referencing is entitled Black Swans and Market Timing and was conducted by Javier Estrada at the IESE Business School in Barcelona, Spain. This important study encompasses more than 100 years of data on the Dow Jones Industrials.

Here is a summary of the highlights of this study:

A $100 investment at the beginning of 1900 turned into $25,746 by the end 2006, and delivered a mean annual compound return of 5.3%.

Missing the best 10 days reduced the terminal wealth by 65% to $9,008, and the mean annual compound return one percentage point to 4.3%.

Avoiding the worst 10 days increased the terminal wealth (with respect to a passive investment) by 206% to $78,781, and the mean annual compound return by more than one percentage point to 6.4%.

Missing the best 20 days reduced the terminal wealth by 83.2% to $4,313, and the mean annual compound return to 3.6%. But avoiding the worst 20 days increased the terminal wealth by 531.5% to $162,588, and the mean annual compound return to 7.2%.

And missing the best 100 days (0.34% of the days considered) reduced the terminal wealth by 99.7% to just $83 ($17 less than the initial capital invested), and the mean annual compound return was reduced to −0.2%.

And finally the most important part of the study show that avoiding the worst 100 days (0.34% of the days considered) increased the terminal wealth by a staggering 43,396.8% to $11,198,734, and more than doubles the mean annual compound return to 11.5%.

There have been many studies over shorter time periods that show very similar results. In all of these studies avoiding the down periods always has much more positive benefit than the negative consequences of skipping the biggest up days. However that critical part of the studies is seldom publicized because the fund industry broadly disseminates only the part of the studies that show the negative consequences of missing a few important up days in order to discourage their investors from ever selling their shares.

I have never seen any evidence that supports the assumption that prudent efforts to skip the biggest down days must necessarily result in missing any critical up days. The critics of market timing are quick to point out that it would be impossible to identify and avoid these particular down days. I would agree that it is impossible to know exactly when these down days may occur. But to achieve our goal of avoiding these down days we can take a shotgun approach rather than the rifle approach that targets only specific days. We can easily identify broad down-trending periods when these down days are most likely to occur. With some effort we can skip the entire period of weakness and achieve the same or even better results than targeting only a few specific days.

Was the 2008 debacle avoidable with simple market timing? Indeed it was and a surprising number of market technicians using very simple methods saw the warning signs in the fall of 2007. I think it might be appropriate at this point to make some general comments in support of market timing. Many critics think of market timing as some sort of crystal ball forecasting, which it is not. Effective market timing is based on careful observations of what is actually happening and not on predicting the future. Let me give you an analogy that might help.

Picture yourself walking down the middle of a narrow road at night and in the distance you see headlights approaching. You are confident that the headlights are real and not an optical illusion. Should you move to the side of the road and wait until the car passes just to be safe even though it might delay your journey by a few minutes? Would that prudent action be based on some dubious prediction of the future or is it merely a disciplined reaction to potential trouble you can easily see coming? If the car happens to stop unexpectedly and turn around would you second guess your decision and think your caution was ill advised? What would you do if you saw another car coming? I would argue that avoiding risk that you can see coming is always a good decision and that is really what using market timing for exits is all about.

We all know that reliably predicting specific future events is impossible. Effective market timing should never be based on illogical predictions.  However most market timing is based on factual observations of reality and no crystal balls or astrological tables are needed.

Now let’s get a bit more specific about timing the exits of equity positions to avoid risk. In more than forty years of research and much trial and error I have concluded that periods of extraordinary price weakness almost always result in further price weakness. The obvious problem with this logic is that stocks go up and down all the time so and accurately defining and recognizing extraordinary price weakness promptly can be very difficult. As you might imagine the magnitude of these normal up and down price movements varies quite a bit from stock to stock and also changes according to the trend direction of the stock. Attempts to apply a fixed percentage decline (8% or 10% are popular) have failed because those percentages are not the best settings for most stocks most of the time. Using the same percentage trailing stops on 5,000 or more stocks is like lining up 5,000 people and trying to fit them all into a size ten shoe.

Setting trailing exits by attempting to identify levels of support are also popular but what qualifies as a valid support level can vary depending on the skills and experience of the person reading the chart. Identifying support levels is a highly subjective approach which appears to work better in hindsight than it does in real time. Also a serious problem occasionally arises if the stock is in a severe downtrend and the previous support levels have all been broken. If you are entering stocks on the weakness, as many value investors prefer, then there may be no support in sight. On the other hand if the stock is in an uptrend and moving at a rapid rate it can quickly climb so far above a previous support level that the exit point is too far away to limit risk to a reasonable amount.

I could go on and explain the shortcomings of many more conventional stop setting techniques but they all suffer from the same basic problem. They fail to accurately identify what is truly abnormal price weakness.  If investors take action prematurely and sell a stock based on less than abnormal price action they often experience a dreaded “whipsaw” where the stock resumes its upward price action and they have sold unnecessarily and miss a valuable opportunity for profits. When this happens investors tend to blame the trailing exit rather than their failure to recognize that the stock was going up and simply buy it back. After a painful “whipsaw” or two the investors vow to never use trailing stops again and they eventually get themselves into serious trouble. Some investors try to avoid costly and frustrating “whipsaws” by setting their exits much further away. But this tactic generally leads to taking much bigger losses than necessary. One popular exit strategy is to risk 25% on every stock.  That approach makes more sense than buy and hold but in most cases a setting a trailing stop that far away results in taking much more risk than necessary.

As the developer of the algorithms used at SmartStops.net I can briefly explain the logic that makes the SmartStops trailing exits so much more accurate and effective than other methods of setting trailing stops. First in order to recognize “abnormal” price weakness we must accurately define “normal” price action. One primary element of that task is to constantly track volatility so that we know how far a stock will normally travel up or down over a particular time period. The direction the stock is headed also has an effect on what is normal price action. Direction needs to be defined as up, down or sideways because there is specific price action that is normal for each of those directions. Also it is important to be able to set the exits further away when a stock is moving up so that we can let the profits run. If we believe, as I do, in the old adage of letting profits run and cutting losses short then it logically follows that in a downtrend our exits should be closer.

Volatility and trend direction vary widely from stock to stock so it easy to see why conventional methods of setting stops can be so futile.  Using the same trailing exit for every stock is not the best way to limit losses and protect capital. The exits need to be very adaptive as the precise definitions of “normal” and “abnormal” change daily.

In conclusion I suggest that modern investors need step up and take control of risk. There is nothing we can do to control the size of profits so let’s take control and limit the size of our losses. As the “Black Swan” and other studies have demonstrated, avoiding losses will accelerate profits dramatically.

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About SmartStops

We are a new service launched to the market in July of 2008. Our mission - to help ensure stock and etf investors stay protected in their positions at all times. see www.smartstops.net

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