“The essence of portfolio management is the management of risks, not the management of returns.” —Benjamin Graham
Why actively manage investment risk?
Why not just buy and hold markets and ride through their large drawdowns?
Losses are asymmetric and loss compounds exponentially.
The larger the loss, the more gain is required to recover the loss to get back to breakeven.
The negative asymmetry of loss starts quickly, losses more than -20% decline start to compound against you exponentially and with a greater magnitude the larger the loss is allowed to grow.
If your investment portfolio experiences a -20% loss, it needs a 25% gain to get back the breakeven value it was before the loss.
At the -30% loss level, you need a 43% gain to get it back.
Diversification is often used as an attempt to manage risk by allocating capital across different markets and assets.
Diversification and asset allocation alone doesn’t achieve the kind of risk management needed to avoid these large declines in value. Global markets can fall together, providing no protection from loss.
For example, global markets all fell during the last two bear markets 2000-2003 and 2007-2009.
It didn’t matter if you had a global allocation portfolio diversified between U.S. stocks, international stocks, commodities, and real estate REITs.
Diversification can fail when you need it most, so there is a regulatory disclosure required: Diversification does not assure a profit or protect against loss.
This is why active risk management to limit downside loss is essential for investment management.
I actively manage loss by knowing the absolute point I’ll exit each individual position and managing my risk level at the portfolio level.
Active risk management, as I use it, applies tactics and systems to actively and dynamically decrease or increase exposure to the potential for loss.
My risk management systems are asymmetric risk management systems. Asymmetric risk management intends to manage risk with the objective of a positive asymmetric risk/reward.
My asymmetric risk management systems are designed to cut losses short, but also protects and manages positions with a profit.
After markets trend up for a while without any significant interruption, investors may become complacent and forget the large damage losses can cause to their capital and their confidence. When investors lose confidence in the markets, they tap-out when their losses are allowed to grow to large.
I prefer to stop the loss before it gets too large. How much is too large depends on the client, but also the math. As seen here, I have a mathematical basis for believing I should actively manage investment risk.
It’s why I’ve been doing it for two decades. Because I understood the math, I knew I had to do it over twenty years ago and developed the systems and tactics that proved to be robust in the devastating bear markets I’ve executed through since then.
Mike Shell is the Founder, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Managed Portfolios and ASYMMETRY® Global Tactical.
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The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.
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