5 Reasons Why Risk Matters In Investing
As investors, our ultimate goal is to make money or returns. Of course, the more the merrier. No one would ever complain about bagging more than they expected. It can even earn you some bragging rights. In fact, you will find no lack of news blasting results of funds or individuals who make phenomenal profits. Risk, on the other hand, is the neglected and silent sibling. You will hardly find any news mentioning someone using a dramatically lower risk. Well, that is unless they deem the returns newsworthy as well.
Now, a 50% return is as good as anyone else’s 50% return no matter what risk they took right? Well, if you are purely looking from the monetary perspective, that is indeed the case. So why should I bother myself with risk?
The Measure of Risk
Before I start, let us first be clear about the risk measure I am talking about. There are many different ways to measure risk… Volatility, VaR, downside risk, drawdowns, breaking them down into asset betas, and many more. Which one to use is debatable but definitely, none are perfect. And you can always look at more than one to get a more comprehensive picture. But for the purpose here, we will be looking at volatility and drawdowns. Because they are simple and useful.
Volatility is mathematically the standard deviation of the percentage change in an asset price over a period of time. The higher the volatility, the riskier the asset is.
Drawdowns are how much you are losing with respect to the previous high. There will be many drawdowns along the way as your portfolio moves up and down making new highs. But of particular interest is the largest drawdowns among all these known as the Maximum Drawdown.
If you are interested in learning the math behind them, you can look it up in a previous post I wrote.
Now, let’s talk about the 5 Reasons Why Risk Matters.
1. Know How Much You Can Lose
Are you surprised that most people are ill-prepared to answer this question: How much are you risking? Or to put it from a layman’s perspective, how much do you expect to lose in say a bad scenario? This is different from how much you are prepared to lose. Anyone can quote a number on the latter based on their whims. But gauging how much you can lose is another matter. Some people can’t wrap a figure around that because they either have never bothered asking this question or have no clue how to estimate them. For quants, this would be inconceivable. If you don’t know how much you might lose, then you don’t know what you are doing.
If you talk to risk professionals, they like to use VAR (Value At Risk). VAR estimates how much you can possibly lose, say X%, over a period of time within a certain confidence level say 95%. Or put it in another way, it tells you that your loss is unlikely to exceed X% within the period 95% of the time. It does not mean your losses can’t exceed that. Given time, it will. And it can exceed by quite a bit since we are talking about tail losses here.
For the bulk of us, we don’t have to go down that track. Simple drawdowns are good enough. It provides you an intuitive estimate because these are the times you lost money. The largest of these drawdowns, or the Maximum Drawdown, lets you know how much you would have lost in the worst case that occurred in history. But having said that, these are historical estimates. So to be conservative, you might want to set expectations for a maximum possible future loss that is larger than that e.g. 1.5x the maximum drawdown.
Now, how useful these estimates are, to a large extent, depends on the historical data. A short history encompassing a bull period will not give you a fair picture of how much you can lose if you run a long-only stock portfolio. The real litmus test for your portfolio is a bear market. So you will need to put on your thinking cap when analyzing the numbers and not just take the output as it is.
2. Know How To Size Up Your Positions
How do you size your positions currently? Arbitrarily? Spread out the bets equally? In the hedge fund industry, we frequently sized based on risk. It is a sensible approach. Because risk is what is driving the returns. No risk no gain right? Some of you may already be sizing things up based on perceived risk. Perhaps, a key difference here is you might size based on more qualitative factors, while we sized based on a quantifiable and scientific basis.
The popular risk parity strategy is a risk-based sizing methodology. As an example, you can start with an equal allocation to bitcoin and a stock index. Unsurprisingly, bitcoin’s movement overwhelms your portfolio. In terms of risk, your portfolio is actually concentrated in bitcoin even though you allocated the same amount of capital to both. So what would make more sense is to size down bitcoin and give more to the stock index so that things are more balanced. The theory is pretty commonsensical. But the question is how much do you size down on bitcoin and how much do you size up on the stock index? Without knowing the math behind volatility and how to break it down within a portfolio setting, you would not be able to arrive at a number.
Besides risk parity, there are other ways you can make use of risk for sizing positions. You can limit the risk of specific assets or positions in your portfolio or even the overall portfolio. This allows you greater precision and flexibility in controlling the risk of your portfolio.
3. Know If You Can Use Leverage
I am sure you read news about those who blew their entire account and more playing futures, shorting options, or dabbling in margin trading. The common thing here is the use of leverage. In simple English, leverage means borrowing more money, whether implicitly or explicitly, to size up your positions beyond what you have. Futures, options, or CFDs are instruments that come with embedded leverage. Margin trading, on the other hand, directly borrows money from the broker so that is explicit.
With that many negative stories, it is no wonder why some people view leverage as something highly dangerous and undesirable. Now, that is pretty much a misconception. Any good tool in the hands of the wrong person is just something waiting to go wrong. The same goes for leverage. Yes, it can amplify your profits, but it can also do the same for your losses.
To make good use of leverage, you need to know how much risk you are already taking. Are you even able to accommodate more? Increasing exposures by multiples to an already high-risk portfolio is what I call digging your own grave. But if you manage your portfolio’s downsides well and the risk is low, to begin with, then a carefully calibrated level of leverage can be a valuable boost.
4. Stay Rational In Market Turmoil
Whether we like it or not, investing is a journey full of emotional ups and downs. Professionals are not spared as well. In a bad patch, tempers rise and curses fly. That’s pretty normal. But what sets good professionals apart is not what they feel but what they do to their trades. Unlike a lot of retail investors who will be overwhelmed with wild thoughts and hitting the panic button, professionals can resist such temptations.
How do they resist taking irrational actions? Experience and having to ride through different regimes help. But what is more critical is they already have a plan and they know their strategy inside out. In particular, they know the risks involved — what they can potentially lose in an unfavorable market situation. And most of the time, these losing streaks will be within the norms of what they plan for. But whatever is the case, they just have to execute according to their plan.
5. Free From Market Timing
Timing the market is one of the favorite pastimes of many retail investors. And this is despite most not having the time, expertise, or information to make good decisions. As a result, many ended up buying high and selling low or missing the boat altogether. So effectively, they are often better off not timing or just going with some regular investment program riding on dollar-cost averaging.
But if you focus on risk, you can implement low-risk strategies that are good at extracting returns from the market. That is what hedge funds do day in day out for a living. The risk parity approach I mentioned earlier is one of them. There are many more — trend following, long/short equities, statistical arbitrage, volatility trading, sector rotation, etc. And you can run multiple lowly correlated strategies in parallel for more robust performance. You can picture this as having diversified streams of income. The objective is to achieve a stable and steadily increasing portfolio without all the roller coaster rides.
Now, if I take this to the extreme and say we have a product that just steadily increases in value over time, would you then bother to time it? The answer is clear. No, you won’t, because you don’t need to.
The conclusion is straightforward. Risk does matter.
Originally published at https://investmentcache.com on January 13, 2021.