Risk Management crash course

No risk framework, no fun

I am pretty certain that you have been reading a good amount of papers and blogs about risk management and how important it is to attain profitable strategies over the longer-term. I am sure you have possibly been applying your own version of a framework and tried out stops and analysed how and where to place them.

The philosophy around risk management is pretty straight forward. Just don’t blow up so you can stay in the game in order to recover losses as fast as possible.

This simple truth, however, is surprisingly different depending on who you ask and what type of investment strategy they follow. A hedge fund, for example, will, without exception, apply a stop loss on their portfolio managers, often broken down into varying levels where their risk or capital will be reduced or increased.

At one of the largest institutions I once worked for I was invited to attend a workshop where senior heads of desks were discussing their risk management strategies. The room was filled with mostly credit or emerging markets focussed managers. I was surprised how many did not have an explicit process when dealing with drawdowns.

I asked the head of the high-yield team, what he would do when faced with drawdowns. He told me in no uncertain terms that he thought that stop losses are total nonsense and that the hard work had to be done in analysing and executing the best trading ideas and nothing else. He had a point. I did, however, point out that hit ratios, even if you’re batting 80% would mean facing 20% of trades losing money and if not properly managed could blow a hole in anyone’s portfolio. He laughed at my comment. The following year, his team faced steep drawdowns as they faced successive defaults in bank-related fixed income securities, losing a year’s worth of returns in a couple of months as a result.

Another group of risk-takers I had the pleasure to observe during my career were following a martingale-type strategy by doubling down on positions when they were down. More often than not, this strategy would work out. In addition, they were leveraging their portfolios wherever they could. Running massive short convexity strategies via the selling of volatility pretty much constantly. This is an actual performance chart of one of their portfolios. Eyeballing the 2020 cliff dive would suggest a peak to trough drawdown of 50%. You’re basically toast if you’re managing professional institutionally money. You’d be toast if that were your personal account in my humble opinion.

Damn you JGBI’s

Yes, I can hear you asking, Paper I am sure you must have had a rough ride at some point in your non-paper investment career? I sure did, not only once. And you know, I think everybody has to go through it and learn from it.

My worst form of a risk management practice gone wrong came from the rather innocuous dealing in Japanese inflation-linked bonds (JGBI). Long story short, after GFC real rates exploded higher and linkers, including TIPS, suffered large losses as a deflationary fear factor grappled markets. A technicality in Japanese inflation-linked bonds was that there was no floor in the principal should there be negative inflation prints. Something which their US counterparts were immune from, depending on how much inflation they had already accrued over their lifetime. The ultimate par value, however, could not drop below 100 which was different from JGBI’s.

I held those linkers in the portfolio as corresponding breakeven inflation rates looked rather attractive. The market tanked, and with it market liquidity evaporated. Bid-Offers were around 15 points! I refused to sell at those levels despite the drawdown, which given the relatively small risk allocation was manageable, but still hurt. I held onto the position for a few more years as liquidity returned to the markets when the Bank of Japan and the Ministry of Finance decided to support the market via liquidity operations. Lesson learned? Liquidity, even in government bonds, can evaporate. I took me few years before I was able to sell those bonds and a small profit. I never touched them again.

Your inner risk management voice

I am strong proponent of a tailored risk management practice which works for your personal style of investing but also suits your risk aversion. Stop losses, while necessary, can impose a somewhat mechanical break to a perfectly valid thesis. The mere fixation of being right rather than counting the beans, however, can be a somewhat difficult inner conflict to pass by. I was there a lot and yes I have stopped out of perfectly awesome positions which went against me and the ripped and performed amazingly.

So, the question for you has also to be whether your ability to stop out is complemented with your willingness to re-enter trades. Some people, I am one of them, doesn’t want to touch the same trade again for a while, and that’s usually where you miss out on the gains. It’s also a reason why systematised strategies, in general, do better as there is zero historical emotion attached to a trade that didn’t work out. Balancing those things, I believe is important to longer-term compounding.

Traffic light approach

As outlined before any approach has to be weighed against the strategy in question and the willingness to tolerate drawdowns. Professoinal money managers rely on their sharpe or sortino ratios to stand out while if you are trading your personal account you possibly don’t care whether you’re down 50% while targeting a 2 or 3 x multiple of returns. Silly but I will not argue over it.

I am more stringent than that as I absolutely detest losing money. So the first thing for me is to decide how much loss tolerance do I want to apply. Typically this is half of my annual return target. So if I am after a 10% return I would typically think of a stop in the region of 5% on the overall portfolio. I then apply a relatively simple traffic light approach.

Green:

If PnL is greater than 50% of annual stop loss, risk limits as normal

Yellow:

If PnL reaches 50% of annual stop loss, risk limits are halved

Limits reinstated on a weekly P&L close above trigger

Amber:

If P&L reaches 75% of annual stop loss, risk limits are halved again.

Limits reinstated to appropriate level on a weekly P&L close above trigger.

Red:

Yearly stop as a hard stop.

This approach allowes me to be strict in dialling up and down of my risk levels while maintaining enough room to bounce and cover losses fast. Keeping in mind that this is on the overall portfolio level, you can in theory apply this also on a trade by trade basis but I will cover this off in another post.

This is enough for today. I will follow up with a deeper look into individual trade sizing and risk management. Again, keep in mind that you have to find a process that works for your style and your willigness to tolerate losses. Taking losses is easy, some might say and that might be true but your overall goal is to increase your bean count and believe when I say that you want to stay in the game at all costs. Down not out is the mantra.

Enjoy and ride on!

Your

Paper Alfa

Music

Paper Alfa is currently obsessed with trying to play this song on his acoustic guitar. What an artist, what a tune. Shout if you want the tabs or tutorial I am using!