Managing Investment Risk in an Uncertain World
Risk management has always played a central role in equity investments. Numerous studies and polls of investors clearly indicate the goals of the vast majority: to earn profits while reducing the risk of losing principle. Most investors are, according to research, sufficiently risk adverse that when presented with two investments with the same return but different levels of risk, they would select the less risky investment. We have selected four popular types of investment philosophies or strategies and will describe the types of risks in each.
The Warren Buffett Model and Risk Management
“Risk comes from not knowing what you’re doing.”– Warren Buffett
Warren Buffett, whose estimated worth is $80B, has long been considered one of the most successful inventors in the world. His investment philosophy provides a proven strategy for outstanding and effective risk management and significant financial gain.
To avoid risk, Buffett strongly advises investors to invest only in what they know: “Never invest in a business you cannot understand.” Peter Lynch, the head of Magellan Funds, made profits of 29.2% for 13 consecutive years (1977-1990) with a similar philosophy: “Never invest in an idea you can’t illustrate with a crayon.”
To avoid risk, Buffett eschews the latest “stock de jour” or whisper numbers or “hot tips.” He is a value investor, a bargain hunter, who looks for undervalued companies with growth potential and shareholder safety. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” To achieve these goals, he garners, before purchasing a stock, everything that he can about a company; no pebble, let alone stone, is left unturned. In stock selection, he employs what he terms a minimal risk approach: look for companies with little or no debt, low share price, significant margin growth, inclusive and positive culture, acceptable cash flow, margin growth, sustainability, and prudent leadership. He also looks for companies that have strong intrinsic value, which he defines as a company’s current value compared to it liquidation value. This approach to risk management allowed him to avoid significant loses during the dot-com bubble of the late 1990s and other market downturns.
Diversification and Risk Management
Eggs and baskets
Diversifying one’s investments in a time-honored method for managing risk. It would be highly risky for an investor to put all of his or her eggs in one basket. Risk management would suggest putting one’s eggs in a number of different baskets. More importantly, however, is the quality of the eggs.
The argument that diversification mitigates risk by spreading it across numerous stocks in various segments of the economy has merit. Reducing loses by spreading risk over a large number of entities is a basic principle of the insurance industry. There is, however, no safety in numbers if one buys mediocre stocks, even over a broad spectrum; diversification will not come to the rescue. “There is no turning,” as the old Scottish adage warns, “a sow’s ear into a silk purse.” Investors may also wish to consider the opportunity cost of diversification; less capital will be placed in equities with outstanding fundamentals and growth potential. Ideally, diversification limits losses with gains, but it also limits gains with offsetting losses.
Diversification is a quantitative hedge against a potential downturn, not a qualitative method of avoiding risk and increasing value. The best shield against a market downturn, we believe, is in careful stock selection based on thorough research and professional advice. Another hedge is to invest in companies that give exposure to multiple sectors, so that diversification is accomplished without sacrificing growth.
Momentum Investing and Risk Management
Follow the trends
Momentum stock trading has become popular during the last decade. It is a strategy in which investors try to capitalize on stocks that are trending higher, often for the last six months to a year, and selling them once they start to decline. Its basic premise is that the present is a continuation of the past. It largely assumes that past performance and historical data will be replicated in current and future periods.
This is a sound premise, but a problem occurs when volatility increases and causes markets and specific stocks to abruptly change direction. When this happens, historical data are much less relevant, and deeper analysis is warranted.
Two thousand and twenty-two will probably experience a rise in volatility, which has been dormant for the past two years. Volatility often has a baleful effect on risk management. When volatility spikes, trends, directions, and patterns are often subverted, causing investors to sell, look for new trends, or lose money.
Momentum strategies have created substantial profits for investors in the last decade, but this was often achieved by making some risky investments. Investors who are risk averse may not feel comfortable with this investing strategy. Risk management can be achieved by balancing momentum investing with a broader understanding of the economic forces in the global economy. Pairing the two approaches offers the ability to react less severely during volatile periods.
ETFs and Risk Management
Security in numbers
An exchange-traded fund (ETF) is a basket of stocks that can be traded on an exchange like an individual stock. Since the fund consists of a number of stocks, its risk is distributed. This provides, then, some of the security and safety of a mutual fund. Unlike a mutual fund, however, ETFs can be traded during the day and may be shorted. Their holdings are declared each day, which offers greater transparency than a mutual fund.
There are risks inherent in ETFs, some of them of a technical and tax nature, which you may wish to discuss with a financial adviser. Some of the more obvious risks: its investments are in a single economic sector, which does not provide the broader diversification of most mutual funds. The underlying assets, like all stock purchases, operate at the whim of the market. Since some assets in ETFs are riskier than others, funds have varying degrees of risk. Many investors come to us with holdings in several ETFs and discover there is little to no diversification among the ETFs they hold. Our advisors have the tools and the resources to generate an analysis of your current holdings and identify concentrated areas of risk exposure.
Another element of risk is that shareholders don’t own the underlying assets, only a portion of the ETF. Since funds are not traded as frequently as individual stocks, liquidation may be delayed, creating a loss risk. Furthermore, ETS may close prematurely if the fund’s assets cannot cover administrative costs. Investors, then, may be forced to sell sooner than they may have intended, sometimes at a loss. About 100 ETFs bite the dust each year. We select ETFs with high daily trading volumes and filter out those who do not meet liquidity standards. We provide our advisors with the tools to identify these types of risks in your portfolio through a complimentary in-depth portfolio analysis of your current holdings.
Risks are present in everything one does every day. Financial markets are highly susceptible to change, emotion, frivolous events, uncertainty, and worry. We advise investors to examine their level of risk, investigate the risk elements of their purchases, and chose an investment philosophy or strategy that suits their individual emotional, financial, and intellectual profile.