Actively Managing Investment Risk

The global market declines in early August offered a fine example of the kind of conditions that cause me to exit my long positions and end up in cash. For me, this is a normal part of my process. I predefine my risk in each position, so I know my risk across the portfolio. For example, I know at what point I’ll sell each position if it falls below a certain point in which I would consider it a negative trend. Since I know my exit in advance for each position, I knew in advance how much I would lose in the portfolio if all of those exits were reached due to market price movements trending against me. That allowed me to control how much my portfolio would lose from its prior peak by limiting it to my predefined amount. I have to take ‘some’ risk in order to have a chance for profits. If I took no risk at all, there could be no profit. The key for me is to take my risk when the reward to risk is asymmetric. That is, when the probability for a gain is much higher than the probability for a loss.

The concept seems simple, but actually doing it isn’t. All of it is probabilistic, never a sure thing.  For example, prices sometimes move beyond the exit point, so a risk control system has to account for that possibility.  More importantly, the portfolio manager has to be able to actually do it. I am a trigger puller. To see the results of over 10 years of my actually doing this, you can visit ASYMMETRY® Managed Accounts.

With global markets in downtrends, this is a great time to listen to my interview with Michael Covel on February 19, 2015. I talked about my concepts of actively directing and controlling risk in advance. It’s now available on Youtube:

Uncharted Territory from the Fed Buying Stocks

I remember sometime after 2013 I told someone “The Fed is buying stocks and that’s partly why stocks have risen so surprisingly for so long”. He looked puzzled and didn’t seem to agree, or understand.

The U.S. Federal Reserve (the “Fed”) has been applying “quantitative easing” since the 2007 to 2009 “global financial crisis”. Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. The Fed implements quantitative easing by buying financial assets from banks and other financial institutions. That raises the prices of those financial assets and lowers their interest rate or yield. It also increases the amount of money available in the economy. The magnitude they’ve done this over the past seven years has never been experience before. They are in uncharted territory.

I was reminded of what I said, “the Fed is buying stocks” when I read comments from Bill Gross in “Gross: Fed Slowly Recognizing ZIRP Has Downside Consequences”. He says companies are using easy money to buy their own stock:

Low interest rates have enabled Corporate America to borrow hundreds of billions of dollars “but instead of deploying the funds into the real economy,they have used the proceeds for stock buybacks. Corporate authorizations to buy back their own stock are running at an annual rate of $1.02 trillion so far in 2015, 18 percent above 2007’s record total of $863 billion, Gross said.

You see, if we want to know the truth about market dynamics; we necessarily have to think more deeply about how markets interact. Market dynamics aren’t always simple and obvious. I said, “The Fed is buying stocks” because their actions is driving the behavior of others. By taking actions to increase money supply in the economy and keep extremely low borrowing rates, the Fed has been driving demand for stocks.

But, it isn’t just companies buying their own stock back. It’s also investors buying stocks on margin. Margin is borrowed money that is used to purchase securities. At a brokerage firm it is referred to as “buying on margin”. For example, if we have $1 million in a brokerage account, we could borrow another $1 million “on margin” and invest twice as much. We would pay interest on the “margin loan”, but those rates have been very low for years. Margin interest rates have been 1 – 2%. You can probably see the attraction. If we invested in lower risk bonds earning 5% with $1 million, we would normally earn 5%, or $50,000 annually. If we borrowed another $1 million at 2% interest and invested the full $2 million at 5%, we would earn another 3%, or $30,000. The leverage of margin increased the return to 8%, or $80,000. Of course, when the price falls, the loss is also magnified. When the interest rate goes up, it reduces the profit. But rates have stayed low for so long this has driven margin demand.

While those who have their money sitting in in bank accounts and CDs have been brutally punished by near zero interest rates for many years, aggressive investors have borrowed at those low rates to magnify their return and risk in their investments. The Fed has kept borrowing costs extremely low and that is an incentive for margin.

In the chart below, the blue line is the S&P 500 stock index. The red line is NYSE Margin Debt. You may see the correlation. You may also notice that recessions (the grey area) occur after stock market peaks and high margin debt balances. That’s the downside: margin rates are at new highs, so when stocks do fall those investors will either have to exit their stocks to reduce risk or they’ll be forced to exit due to losses. If they don’t have a predefined exit, their broker has one for them: “a margin call”.

Current Margin Debt Stock MarginSource: http://www.advisorperspectives.com/dshort/charts/markets/nyse-margin-debt.html?NYSE-margin-debt-SPX-since-1995.gif

If you noticed, I said, “They are in uncharted territory”. I am not. I am always in uncharted territory, so I never am. I believe every new moment is unique, so I believe everyone is always in uncharted territory. Because I believe that, I embrace it. I embrace uncertainty and prepare for anything that can happen. It’s like watching a great movie. It would be no fun if we knew the outcome in advance.

 

What You Need to Know About Long Term Bond Trends

There is a lot of talk about interest rates and bonds these days – for good reason. You see, interest rates have been in a downtrend for decades (as you’ll see later). When interest rates are falling, the price of bonds go up. I wrote in “Why So Stock Market Focused?” that you would have actually been better off investing in bonds the past 15 years over the S&P 500 stock index.

However, the risk for bond investors who have a fixed bond allocation is that interest rates eventually trend up for a long time and their bonds fall.

This year we see the impact of rising rates and the impact of falling bond prices in the chart below of the 20+ year Treasury bond. It’s down -15% off its high and since the yield is only around 2.5% the interest only adds about 1% over this period for a total return of -14.1%. Up until now, this long term Treasury index has been a good crutch for a global allocation portfolio. Now it’s more like a broken leg.

But, that’s not my main point today. Let’s look at the bigger picture. Below is the yield (interest rate) on the 10-Year U.S. government bond. Notice that the interest rate was as high as 9.5% in 1990 and has declined to as low as 1.5%. Just recently, it’s risen to 2.62%. If you were going to buy a bond for future interest income payments, would you rather invest in one at 9.5% or 1.5%? If you were going to lend money to someone, which rate would you prefer to receive? What is a “good deal” for you, the lender?

I like trends and being positioned in their direction since trends are more likely to continue than reverse, but they usually do eventually reverse when inertia comes along (like the Fed). If you care about managing downside risk you have to wonder: How much could this trend reverse and what could its impact be on fixed bond holdings? Well, we see below that the yield has declined about -70%. If we want to manage risk, we have to at least expect it could swing the other way.

One more observation. Germany is one of the largest countries in the world. Since April, the 10-year German bond interest rate has reversed up very sharp. What if U.S bonds did the same?

As I detailed in “Allocation to Stocks and Bonds is Unlikely to Give us What We Want” bonds are often considered a crutch for a global asset allocation portfolio. If you care about managing risk, you may consider that negative correlations don’t last forever. All trends change, eventually. You may also consider your risk of any fixed positions you have. I prefer to actively manage risk and shift between global markets based on their directional trends rather than a fixed allocation to them.

The good news is: by my measures, many bond markets have declined in the short term to a point they should at least reserve back up at least temporarily. What happens after that will determine if the longer trend continues or begins to reverse. The point is to avoid complacency and know in advance at what point you’ll exit to cut losses short…

As they say: “Past performance is no guarantee of the future“.

The Volatility Index (VIX) is Getting Interesting Again

In the last observation I shared on the CBOE Volatlity index (the VIX) I had been pointing out last year the VIX was at a low level and then later started trending up. At that time, many volatility traders seemed to think it was going to stay low and keep going lower – I disagreed. Since then, the VIX has remained at a higher average than it had been – up until now. You can read that in VIX® gained 140%: Investors were too complacent.

Here it is again, closing at 12.45 yesterday, a relatively low level for expected volatility of the S&P 500 stocks. Investors get complacent after trends drift up, so they don’t price in so much fear in options. Below we observe a monthly view to see the bigger picture. The VIX is getting down to levels near the end of the last bull market (2007). It could go lower, but if you look closely, you’ll get my drift.

Chart created by Shell Capital with: http://www.stockcharts.com

Next, we zoom in to the weekly chart to get a loser look.

Chart created by Shell Capital with: http://www.stockcharts.com

Finally, the daily chart zooms in even more.

Chart created by Shell Capital with: http://www.stockcharts.com

The observation?

Options traders have priced in low implied volatility – they expect volatility to be low over the next month. That is happening as headlines are talking about stock indexes hitting all time highs. I think it’s a sign of complacency. That’s often when things change at some point.

It also means that options premiums are generally a good deal (though that is best determined on an individual security basis). Rather than selling premium, it may be a better time to buy it.

Let’s see what happens from here…

My 2 Cents on the Dollar

The U.S. Dollar ($USD) has gained about 20% in less than a year. We observe it first in the weekly below. The U.S. Dollar is a significant driver of returns of other markets. For example, when the U.S. Dollar is rising, commodities like gold, oil, and foreign currencies like the Euro are usually falling. A rising U.S. Dollar also impacts international stocks priced in U.S. Dollar. When the U.S. Dollar trends up, many international markets priced in U.S. Dollars may trend down (reflecting the exchange rate). The U.S. Dollar may be trending up in anticipation of rising interest rates.

dollar trend weekly 2015-04-23_16-04-40

Chart created by Shell Capital with: http://www.stockcharts.com

Now, let’s observe a shorter time frame- the daily chart. Here we see an impressive uptrend and since March a non-trending indecisive period. Many trend followers and global macro traders are likely “long the U.S. Dollar” by being long and short other markets like commodities, international stocks, or currencies.

dollar trend daily 2015-04-23_16-05-04

Chart created by Shell Capital with: http://www.stockcharts.com

This is a good example of understanding what drives returns and risk/reward. I consider how long the U.S. Dollar I am and how that may impact my positions if this uptrend were to reverse. It’s a good time to pay attention to it to see if it breaks back out to the upside to resume the uptrend, or if it instead breaks down to end it. Such a continuation or reversal often occurs from a point like the blue areas I highlighted above.

That’s my two cents on the Dollar…

How long are you? Do you know?

Asymmetric Nature of Losses and Loss Aversion

Loss Aversion:

“In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman.”

For most people, losing $100 is not the same as not winning $100. From a rational point of view are the two things the same or different?

Most economist say the two are the same. They are symmetrical. But I think that ignores some key issues.

If we have only $10 to eat on today and that’s all we have, if we lose it, we’ll be in trouble: hungry.

But if we have $10 to eat on and flip a coin in a bet and double it to $20, we may just eat a little better. We’ll still eat. The base rate: survival.

They say rationally the two are the same, but that isn’t true. They aren’t the same. The loss makes us worse off than we started and it may be totally rational to feel worse when we go backwards than we feel good about getting better off. I don’t like to go backwards, I prefer to move forward to stay the same.

Prospect Theory, which found people experience a loss more than 2 X greater than an equal gain, discovered the experience of losses are asymmetric.

Actually, the math agrees.

You see, losing 50% requires a 100% gain to get it back. Losing it all is even worse. Losses are indeed asymmetric and exponential on the downside, so it may be completely rational and logical to feel the pain of losses asymmetrically. Experience the feeling of loss aversions seems to be the reason a few of us manage investment risk and generate a smoother return stream rather than blow up.

To see what the actual application of asymmetry to portfolio management looks like, see: http://www.asymmetrymanagedaccounts.com/global-tactical/

 

asymmetry impact of loss

Asymmetric Sector Exposure in Stock Indexes

When you look at the table below and see the sector exposure percents, what do you observe? Do these allocations make sense?

asymmetric sector ETF expsoure S&P 500 2015-03-24_16-39-11

That is the sector exposure of the S&P 500 stock index: I used the iShares S&P 500 ETF for a real-world proxy. The source of each image is the index website on iShares, which you can see by clicking on the name of the index ETF.

  • Asymmetric is an imbalance. That is, more of one thing, less of another.
  • A sector is a specific industry, like Energy (Exxon Mobil) or Telecom (Verizon).
  • Exposure is the amount of the position size or allocation.

Most of the sector exposure in the S&P 500 large company stock index is Technology, Financials, Healthcare, and Consumer Discretionary. Consumer Staples, Energy, Materials, Utilities, and Telecommunications have less than 10% exposure each. Exposure to Materials, Utilities, and Telecommunications are almost non-existent. Combined, those three sectors are less than 10% of the index. Industrial has 10% exposure by itself.  But this index is 500 large companies, what about mid size and small companies?

asymmetric sector expsoure S&P 500 2015-03-24_16-39-11

Below is the iShares Core S&P Mid-Cap ETF. Most of the sector exposure in the S&P Mid size stock index is Technology, Financials, Industrial. Healthcare, and Consumer Discretionary. Consumer Staples, Energy, Materials, Utilities, and Telecommunications have less than 10% exposure each. Exposure to Materials, Utilities, and Telecommunications are almost non-existent.

asymmetric sector exposure  S&P Mid-Cap ETF

We see this same asymmetric sector exposure theme repeat in the iShares S&P Small Cap index. Half of the sectors are make up most of the exposure, the other very little.

asymmetric sector exposure S&P small cap

This is just another asymmetric observation… the next time you hear someone speak of the return of a stock index, consider they are really speaking about the return profile of certain sectors. And, these sector weightings may change over time.

Diversification Alone is No Longer Sufficient to Temper Risk…

That was the lesson you learned the last time stocks became overvalued and the stock market entered into a bear market.

In a Kiplinger article by Fred W. Frailey interviewed Mohamed El-Erian, the PIMCO’s boss, (PIMCO is one of the largest mutual fund companies in the world) he says “he tells how to reduce risk and reap rewards in a fast-changing world.” This article “Shaking up the Investment Mix” was written in March 2009, which turned out the be “the low” of the global market collapse.

It is useful to revisit such writing and thoughts, especially since the U.S. stock market has since been overall rising for 5 years and 10 months. It’s one of the longest uptrends recorded and the S&P 500 stock index is well in “overvalued” territory at 27 times EPS. At the same time, bonds have also been rising in value, which could change quickly when rates eventually rise. At this stage of a trend, asset allocation investors could need a reminder. I can’t think of a better one that this:

Why are you telling investors they need to diversify differently these days?

The traditional approach to diversification, which served us very well, went like this: Adopt a diversified portfolio, be disciplined about rebalancing the asset mix, own very well-defined types of asset classes and favor the home team because the minute you invest outside the U.S., you take on additional risk. A typical mix would then be 60% stocks and 40% bonds, and most of the stocks would be part of Standard & Poor’s 500-stock index.

This approach is fatigued for several reasons. First of all, 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.

But, you know, they say a picture is worth a thousand words.

Since we are talking about downside risk, something that is commonly hidden when only “average returns” are presented, below is a drawdown chart. I created the drawdown chart using YCharts which uses total return data and the “% off high”. The decline you see from late 2007 to 2010 is a dradown: it’s when the investment value is under water. Think of this like a lake. You can see how the average of the data wouldn’t properly inform you of what happens in between.

First, I show PIMCO’s own allocation fund: PALCX: Allianz Global Allocation Fund. I include an actively managed asset allocation that is very large and popular with $55 billion invested in it: MALOX: BlackRock Global Allocation. Since there are many who instead believe in passive indexing and allocation, I have also included DGSIX: DFA Global Allocation 60/40 and VBINX: Vanguard Balanced Fund. As you can see, they have all done about the same thing. They declined about -30% to -40% from October 2007 to March 2009. They also declined up to -15% in 2011.

Vanguard DFA BlackRock PIMCO Asset Allcation

Charts are courtesy of http://ycharts.com/ drawn by Mike Shell

Going forward, the next bear market may be very different. Historically, investors consider bond holdings to be a buffer or an anchor to a portfolio. When stock prices fall, bonds haven’t been falling nearly as much. To be sure, I show below a “drawdown chart” for the famous actively managed bond fund PIMCO Total Return and for the passive crowd I have included the Vanguard Total Bond Market fund. Keep in mind, about 40% of the allocation of the funds above are invested in bonds. As you see, bonds dropped about -5% to -7% in the past 10 years.

PIMCO Total Return Bond Vanguard Total Bond

Charts are courtesy of http://ycharts.com/ drawn by Mike Shell

You may have noticed the end of the chart is a drop of nearly -2%. Based on the past 10 years, that’s just a minor decline. The trouble going forward is that interest rates have been in an overall downtrend for 30 years, so bond values have been rising. If you rely on bonds being a crutch, as on diversification alone, I agree with Mohamed El-Erian the Chief of the worlds largest bond manager:

“…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.”

But, don’t wait until AFTER markets have fallen to believe it.

Instead, I apply active risk management and directional trend systems to a global universe of exchange traded securities (like ETFs). To see what that looks like, click: ASYMMETRY® Managed Accounts

Top Traders Unplugged Interview with Mike Shell: Episode 1 & 2

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

As I approach the 10-year milestone of managing ASYMMETRY® Global Tactical as a separately managed account, I wanted to share my recent interview with Top Traders Unplugged. Niels Kaastrup-Larsen is the host of Top Traders Unplugged in Switzerland. Niels has been in the hedge fund industry for more than twenty years, working for some of the largest hedge funds in the world. He asks a lot of outstanding questions about life and how I offer a global tactical strategy that is normally only offered in a hedged fund in a separately managed account. And with experience comes depth of knowledge, so our conversation lasted over two hours and is divided into two episodes.

Click the titles to listen.

Episode 1

Why You Don’t Want Symmetry in Investing | Mike Shell, Shell Capital Management | #71

“It’s not about trying to make all the trades a winner – it’s about having the average win be much greater than the average loss – and that is asymmetry.” – Mike Shell

Episode 2

He Adds Value to His System | Mike Shell, Shell Capital Management | #72

“In the second part of our talk with Mike Shell, we delve into the specifics of his program and why most of his clients have 100% of their investments with his firm. He discusses backtesting, risk management, and the differences between purely systematic systems and systems with a discretionary element. Listen in for an inside look at this fascinating firm.” – Niels Kaastrup-Larsen

Direct links:

Episode 1

http://toptradersunplugged.com/why-you-dont-want-symmetry-in-investing-mike-shell-shell-capital-management/

iTunes: https://itunes.apple.com/us/podcast/why-you-dont-want-symmetry/id888420325?i=335354134&mt=2

Episode 2

http://toptradersunplugged.com/when-systematic-programs-arent-fully-systematic-mike-shell-shell-capital-management/

iTunes: https://itunes.apple.com/us/podcast/he-adds-value-to-his-system/id888420325?i=335582098&mt=2

 

For more information, visit ASYMMETRY® Managed Accounts.

Mike Shell Interview 2 with Michael Covel on Trend Following

As I approach the 10-year milestone of managing ASYMMETRY® Global Tactical as a separately managed account, I wanted to share my second interview with MIchael Covel on Trend Following with Michael Covel.

Many studies show that most investors, including professionals, have poor results over a full market cycle of both bull and bear markets. That necessarily means if I am creating good results, I must be believing and doing something very different than most people. In this 33 minute conversation, Michael Covel brings it out!

This is my second interview with Michael Covel, a globally famous author of several outstanding books like “Trend Following: How Great Traders Make Millions in Up or Down Markets“. I was his 4th interview when he started doing audio interviews 3 years ago and now our 2nd follow up is episode 320! For all his hard work and seeking the truth, “Trend Following with Michael Covel” is a top-ranked podcast around the world. He is in Vietnam during our interview. In 33 minutes, we describe what a true edge really is, which is how I’ve been able to create the results I have over these very challenging 10 years. And, what investors need to know today.

To listen, click: Mike Shell Interview with Michael Covel

Or, find Episode 320 in iTunes at “Trend Following with Michael Covel

For more information about my investment program, visit ASYMMETRY® Managed Accounts.

 

Mike Shell Interview 2 with Michael Covel on Trend Following Radio

This is When MPT and VaR Get Asset Allocation and Risk Measurement Wrong

I was talking to an investment analyst at an investment advisory firm about my ASYMMETRY® Managed Account and he asked me what the standard deviation was for the portfolio. I thought I would share with you and explain this is how the industry gets “asset allocation” and risk measurement and management wrong. You see, most people have poor results over a full market cycle that includes both rising and falling price trends, like global bull and bear markets, recessions, and expansions. Quantitative Analysis of Investor Behavior, SPIVA, Morningstar, and many academic papers have provided empirical evidence that most investors (including professionals) have poor results over the long periods. For example, they may earn gains in rising conditions but lose their gains when prices decline. I believe the reason is they get too aggressive at peaks and then sell in panic after losses get too large, rather than properly predefine and manage risk.

You may consider, then, to have good results over a long period, I necessarily have to believe and do things very different than most people.

On the “risk measurement” topic, I thought I would share with you a very important concept that is absolutely essential for truly actively controlling loss. The worst drawdown “is” the only risk metric that really matters. Risk is not the loss itself. Once we have a loss, it’s a loss. It’s beyond the realm of risk. Since risk is the possibility of a loss, then how often it has happened in the past and the magnitude of the historical loss is the mathematical expectation. Beyond that, we must assume it could be even worse some day. For example, if the S&P 500 stock index price decline was -56% from 2007 to 2009, then we should expect -56% is the loss potential (or worse). When something has happened before, it suggests it is possible again, and we may have not yet observed the worst decline in the past that we will see in the future.

The use of standard deviation is one of the very serious flaws of investors attempting to measure, direct, and control risk. The problem with standard deviation is that the equation was intentionally created to simplify data. The way it is used draws a straight line through a group of data points, which necessarily ignores how far the data really spreads out. That is, standard deviation is intended to measure how far the data spreads out, but it actually fails to absolutely highlight the true high point and low point. Instead, it’s more of an average of those points. Yet, it’s the worst-case loss that we really need to focus on. I believe in order to direct and control risk, I must focus on “how bad can it really get”. Not just “on average” how bad it can get. The risk in any investment position is at least how much it has declined in the past. And realizing it could be even worse some day. Standard deviation fails to reflect that in the way it is used.

Consider that as prices trend up for years, investors become more and more complacent. As investors become complacent, they also become less indecisive as they believe the recent past upward trend will continue, making them feel more confident. On the other hand, when investors feel unsure about the future, their fear and indecisiveness is reflected as volatility as the price churns up and down more. We are always unsure about the future, but investors feel more confident the past will continue after trends have been rising and volatility gets lower and lower. That is what a peak of a market looks like. As it turns out, that’s just when asset allocation models like Modern Portfolio Theory (MPT) and portfolio risk measures like Value at Risk (VaR) tell them to invest more in that market – right as it reaches it’s peak. They invest more, complacently, because their allocation model and risk measures tell them to. An example of a period like this was October 2007 as global stock markets had been rising since 2003. At that peak, the standard deviation was low and the historical return was at it highest point, so their expected return was high and their expected risk (improperly measured as historical volatility) was low. Volatility reverses the other way at some point

What happens next is that the market eventually peaks and then begins to decline. At the lowest point of the decline, like March 2009, the global stock markets had declined over -50%. My expertise is directional price trends and volatility, so I can tell you from empirical observation that prices drift up slowly, but crash down quickly. The below chart of the S&P 500 is a fine example of this asymmetric risk.

stock index asymmetric distribution and losses

Source: chart is drawn by Mike Shell using http://www.stockcharts.com

At the lowest point after prices had fallen over -50%, in March 2009, the standard deviation was dramatically higher than it was in 2007 after prices had been drifting up. At the lowest point, volatility is very high and past return is very low, telling MPT and VaR to invest less in that asset.

In the 2008 – 2009 declining global markets, you may recall some advisors calling it a “6 sigma event”. That’s because the market index losses were much larger than predicted by standard deviation. For example, if an advisors growth allocation had an average return of 10% in 2007 based on its past returns looking back from the peak and a standard deviation of 12% expected volatility, they only expected the portfolio would decline -26% (3 standard deviations) within a 99.7% confidence level – but the allocation actually lost -40 or -50%. Even if that advisor properly informed his or her client the allocation could decline -26% worse case and the client provided informed consent and acceptance of that risk, their loss was likely much greater than their risk tolerance. When the reach their risk tolerance, they “tap out”. Once they tap out, when do they ever get back in? do they feel better after it falls another -20%? or after it rises 20%? There is no good answer. I want to avoid that situation.

You can see in the chart below, 3 standard deviations is supposed to capture 99.7% of all of the data if the data is a normal distribution. The trouble is, market returns are not a normal distribution. Instead, their gains and losses present an asymmetrical return distribution. Market returns experience much larger gains and losses than expected from a normal distribution – the outliers are critical. However, those outliers don’t occur very often: maybe every 4 or 5 years, so people have time to forget about the last one and become complacent.

symmetry normal distribution bell curve black

Source: http://en.wikipedia.org/wiki/68%E2%80%9395%E2%80%9399.7_rule

My friends, this is where traditional asset allocation like Modern Portfolio Theory (MPT) and risk measures like Value at Risk (VaR) get it wrong. And those methods are the most widely believed and used . You can probably see why most investors do poorly and only a very few do well – an anomaly.

I can tell you that I measure risk by how much I can lose and I control my risk by predefining my absolute risk at the point of entry and my exit point evolves as the positions are held. That is an absolute price point, not some equation that intentionally ignores the outlier losses.

As the stock indexes have now been overall trending up for 5 years and 9 months, the trend is aged. In fact, according to my friend Ed Easterling at Crestmont Research, at around 27 times EPS the stock index seems to be in the range of overvalued. In his latest report, he says:

“The stock market surged over the past quarter, adding to gains during 2014 that far exceed underlying economic growth. As a result, normalized P/E increased to 27.2—well above the levels justified by low inflation and interest rates. The current status is approaching “significantly overvalued.”

At the same time, we shouldn’t be surprised to eventually see rising interest rates drive down bond values at some point. It seems from this starting point that simply allocating to stocks and bonds doesn’t have an attractive expected return. I believe a different strategy is needed, especially form this point forward.

In ASYMMETRY® Global Tactical, I actively manage risk and shift between markets to find profitable directional price trends rather than just allocate to them. For more information, visit http://www.asymmetrymanagedaccounts.com/global-tactical/

 

“There is always a disposition in people’s minds to think that existing conditions will be permanent …

“There is always a disposition in people’s minds to think the existing conditions will be permanent,” Dow wrote, and went on to say: “When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which make it unlike its predecessors and give assurance of permanency. The fact pertaining to all conditions is that they will change.”  – Charles Dow, 1900

Source: Lo, Andrew W.; Hasanhodzic, Jasmina (2010-08-26). The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals (Kindle Locations 1419-1423). Wiley. Kindle Edition.

You can probably see from Dow’s quote how trends do tend to continue, just because enough people think they will. However, price trends can continue into an extreme or a “bubble” just because people think they will continue forever. I like to ride a trend to the end when it bends and then be prepared to exit when it does finally reverse, or maybe reduce or hedge off some risk when the probability seems high of a change.

idowcha001p1

Image source: Wikipedia

Charles Henry Dow; November 6, 1851 – December 4, 1902) was an American journalist who co-founded Dow Jones & Company. Dow also founded The Wall Street Journal, which has become one of the most respected financial publications in the world. He also invented the Dow Jones Industrial Average as part of his research into market movements. He developed a series of principles for understanding and analyzing market behavior which later became known as Dow theory, the groundwork for technical analysis.

The Holiday Party: Mindset of the Active Risk Manager

holiday parties

I keep hearing of symptoms of this awful virus going around. I’ll spare you of the details, but it involves both ends around the porcelain bowl. We’ve all been there, done that, and probably consider it a “bad outcome”.

Then, we have all these holiday party plans to spend time with friends and family, knowing this ‘bug’ is contagious and spreading. Hearing about it, the natural mindset of the active risk manager is to ask:

“Has anyone at the party had the flu recently?”

You wonder if you’re entering into a high risk of a bad outcome. Most people may not even consider it, and it’s those people who will probably be there spreading it around! I know people who never consider the possibility of a bad outcome; they tend to be the ones who have the worst outcomes, more often. Others may be overly afraid of things that may never happen, so they miss out on life. Some even worry about things they fear so much they experience those things, even when they don’t happen.

The active risk manager internally thinks of risk.

Let’s first use the dictionary to better understand the meaning of “active”:

1. engaged in action; characterized by energetic work, participation, etc.; busy: an active life.

2. being in a state of existence, progress, or motion:

3. involving physical effort and action :active sports.

4. having the power of quick motion; nimble: active as a gazelle.

5. characterized by action, motion, volume, use, participation, etc.

So, let’s say that to be active is to be engaged in action, participate, an active life, progress, nimble, motion, and even a state of existence.

Risk is exposure to the possibility of a bad outcome. When we are speaking of money, risk is the exposure to the possibility of loss. If we incur a loss, that isn’t a risk, that’s an actual loss. Some people believe that uncertainty is risk, but we always have uncertainty. So, risk is the exposure to a chance or possibility of loss. It’s the exposure that is the risk, the chance or possibility is always there. So, your risk of loss is your choice. We decide it in advance.

To manage is to take charge of, handle, direct, govern, or control through action.

A bad outcome in money management may be losing money, or in life it may be anything we perceive as unwanted. We can’t be certain about an outcome. Uncertainty is something we live with every day and in all things, so we may as well embrace it and enjoy not knowing the outcome of things in advance. So, risk is the exposure to a chance or possibility of loss. It’s the exposure that is the risk, the chance or possibility is always there. So, your risk of loss is your choice. We decide it in advance.

So, an active risk manager, like me, is someone who engages in the action of actively and intentionally directing and controlling the exposure to a bad outcome. Because I actively management my risks, I am able to trade and invest in things other people perceive as risky, but they aren’t to me because I define my risk exposure and control it. Because active risk management is not only a learned skill I have advanced for myself but also something that is a natural part of me and who I am, I am also able to live my life enjoying and even embracing change and uncertainty. Yet, I do that initially and naturally thinking of what my risk is. Once I understand my risk, I manage it, and then accept it for what I’ve decided it will be, and then I let it all unfold as it will. I control what I can and let the rest do what it’s going to do.

You see, it’s also a big risk to not experience life. Studies show that happiness is more driven by new experiences than any other thing. Hedonic Adaptation means that we tend to get used to things and adapt, good or bad. Broadening our horizons makes and keeps us happy, doing the same old things leads to a dull and less happy life. Much of our happiness comes from new experiences and change, because we get used to even the finest and fastest new car and eventually it becomes our new normal.

Although I feel a strong obligation to keep myself well, I’m not going to miss spending time with people I enjoy. Instead, I’ll take my chances and deal with, and actively manage, any bad outcome that arises from it. So, consider your risks, then get out there and enjoy yourself with new experiences. Even if you get sick for a few days, that too shall eventually pass.

Merry Christmas!

Asymmetrical Risk Definition and Symmetry: Do you Really Want Balance?

Asymmetric is imbalance, uneven, or not the same on both sides.

Risk is the possibility of losing something of value, or a bad outcome. The risk is the chance or potential for a loss, not the loss itself. Once we have a loss, the risk has shifted beyond a possibility to a real loss. The investment or position itself isn’t the risk either, risk is the possibility we may lose money in how we manage and deal with it.

Asymmetrical Risk, then, is the potential for gains and losses on an investment or trade are uneven.

When I speak of asymmetric risk, I may also refer to the probability for gains and losses that are imbalanced, for those of us who can determine probability. If the probability of losing something or a bad outcome is asymmetric, it means the risk isn’t the same as the reward.

Asymmetric risk can also refer to the outcome for profits and losses that are imbalanced, after we have sold a position, asset, or investment.

Some examples:

If we risk $10, but earn $10, the risk was symmetrical.

  • We risked $10
  • We earned $10 – we just broke even (symmetry).

Symmetry is the outcome when you balance risk and reward.

If we risk $10, but earn $20, the risk was positively asymmetric.

  • We risked $10
  • We earned $20

If we risk $10, but lose $10, the risk was symmetrical.

  • We risked $10
  • We lost $10 – we lost the same as we risked.

If we risk $10, but lose $20, the risk was an asymmetric risk.

  • We risked $10
  • We lost $20 – we lost even more than we though we risked.

Strangely, I often hear investment advisers say they want to balance risk and reward through their asset allocation.

Do you?

It was when I noticed my objective of imbalancing profit and loss, risk and reward, was so different from others that I knew I have a unique understanding and perception of the math and I could apply it to portfolio management.

You can probably see how some investors earn gains for years, then lose those gains in the following years, then earn gains again, then lose them again.

That’s a result of symmetry and its uncontrolled asymmetrical risk.

You can probably see why my focus is ASYMMETRY® so deeply that the word is my trademark.

The Mistake is Not Taking the Loss: Cut Your Losses and Move on

One of the keys to managing investment risk is cutting losers before they become large losses. Many people have difficulty selling at a loss because they believe it’s admitting a mistake. The mistake isn’t taking a loss, the mistake is to NOT take the loss. I cut losses short all the time, that’s why I don’t have large ones. I’ve never taken a loss that was a mistake. I predetermine my risk by determining before I even buy something at what point I’ll get out if I am wrong. If I enter at $50, my methods may determine if it falls to $45 that trend I wanted to get in is no longer in place and I should get out. So when I enter a position in any market, I know how I’ll cut my loss short before I even get in. It’s the exit, not the entry, that determines the outcome. I don’t know in advance which will be a winner or loser or how much it will gain or lose. For me, not taking the loss, would be the mistake.

I thought of this when a self-proclaimed old-timer admitted to me he still holds some of the popular stocks he bought the late 90’s. Many of those stocks are no longer in business, but below we revisit the price trend and total return of some of the largest and most popular stocks promoted in the late 90’s. The black line is Cisco Systems (CSC), Blue is AT&T (T), Red is Pfizer (PFE), and green is Microsoft (MSFT). AT&T’s roots stretch back to 1875, with founder Alexander Graham Bell’s invention of the telephone. Pfizer started in 1849 “With $2,500 borrowed from Charles Pfizer’s father, cousins Charles Pfizer and Charles Erhart, young entrepreneurs from Germany, opened Charles Pfizer & Company as a fine-chemicals business”. At one point during the late 90’s “tech bubble” Microsoft and Cisco Systems were valued more than many countries. But the chart below shows if you did buy and held these stocks nearly 20 years later you would have held losses for many years and many of them are just now showing a profit.

tech bubble leaders 2014-11-15_07-04-53

chart courtesy of http://www.stockcharts.com

The lesson to cut losses short rather than allow them to become large losses came from a book published in 1923.

“Money does not give a trader more comfort, because, rich or poor, he can make mistakes and it is never comfortable to be wrong. And when a millionaire is right his money is merely one of his several servants. Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocketbook and to the soul.”

-Reminiscences of a Stock Operator (1923)

If you are unfamiliar with the classic, according to Amazon:

Reminiscences of a Stock Operator is a fictionalized account of the life of the securities trader Jesse Livermore. Despite the book’s age, it continues to offer insights into the art of trading and speculation. In Jack Schwagers Market Wizards, Reminiscences was quoted as a major source of stock trading learning material for experienced and new traders by many of the traders who Schwager interviewed. The book tells the story of Livermore’s progression from day trading in the then so-called “New England bucket shops,” to market speculator, market maker, and market manipulator, and finally to Wall Street where he made and lost his fortune several times over. Along the way, Livermore learns many lessons, which he happily shares with the reader.

 

 

VIX® gained 140%: Investors were too complacent

Several months ago I started sharing some of my observations about the VIX ( CBOE Volatility Index). The VIX had gotten to a level I considered low, which implied to me that investors were too complacent, were expecting too low future volatility, and option premiums were generally cheap. After the VIX got down to levels around 11 and 12 and then started to move up, I pointed out the VIX seemed to be changing from a downward longer term trend to a rising trend.

As I was sharing my observations of the directional trend and volatility of VIX that I believed was more likely to eventually go up than down, it seemed that most others were writing just the opposite. I know that many volatility traders mostly sell volatility (options premium), so they prefer to see it fall.

As you can see in the chart below, The VIX has increased about 140% in just a few weeks.

VIX october

Chart courtesy of http://www.stockcharts.com

For those who haven’t been following along, you may consider reading the previous observations:

A VIX Pop Then Back to Zzzzzzzz? We’ll see

Asymmetric VIX

VIX Shows Volatility Still Low, But Trending

VIX Back to Low

The VIX is Asymmetric, making its derivatives an interesting hedge

Is the VIX an indication of fear and complacency?

What does a VIX below 11 mean?

What does the VIX really represent?

The VIX, my point of view

The VIX, as I see it…

Volatility Risk Premium

Declining (Low) Volatility = Rising (High) Complacency

Investors are Complacent

 

Asymmetric Risks of Momentum Strategies

Asymmetric Risk

Asymmetric Risks of Momentum Strategies is another attempt to explain the excess returns of momentum using the Capital Asset Pricing Model. The paper discusses a theory of risk asymmetry in momentum risk/reward, but not how to gain an edge from it.

Abstract:

I provide a novel risk-based explanation for the profitability of global momentum strategies. I show that the performance of past winners and losers is asymmetric in states of the global market upturns and downturns. Winners have higher downside market betas and lower upside market betas than losers, and hence their risks are more asymmetric. The winner-minus-loser (WML) momentum portfolios are subject to the downside market risk, but serve as a hedge against the upside market risk. The high return of the WML portfolios is a compensation for their high risk asymmetry. After controlling for this risk asymmetry, the momentum portfolios do not yield significant abnormal returns, and the momentum factor becomes insignificant in the cross-section. The two-beta CAPM with downside risk explains the cross-section of returns to global momentum portfolios well.
Source:Dobrynskaya, Victoria, Asymmetric Risks of Momentum Strategies (March 2014). Available at SSRN: http://ssrn.com/abstract=2399359 or http://dx.doi.org/10.2139/ssrn.2399359

 

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