Risk Management In Action

Risk management is a key part of the Best Ideas investment strategies. That’s because we prioritise the preservation of capital and out-performance over the long term. The best way to do this is keep losses small through risk management.

The following examples from the Best Ideas Competitive Edge Portfolio are a reminder of:

The effectiveness of risk management in protecting capital

There are no free lunches

Designing an investment strategy to work on average, over time, not every time

Take Stock A for example. We purchased the stock because a growth manager we track, filed several 13D notices. 13D filings must be issued within ten days of a fund manager’s purchase of a substantial position.That is, 5% or more of a company’s stock. A new filing must also be submitted for a further 1% change in a substantial holding. Consequently, 13D filings are a timely signal of manager conviction.

Stock A was purchased in July for an average price of $19.44. Later that month, it reached an intra-day high of more than $21.00. Our risk management framework uses tools such as stops to dynamically manage risk

The stock began to fall in price in Late July and was consequently sold at $18.20 for a small loss of -2.06%. The impact of the loss at the overall portfolio-level was only -0.06%. 

The stock has continued to fall, down a further -19.46% (23/8/2019). In this case, risk management protected the strategy against an estimated loss of -0.59% at the overall portfolio-level.

Risk management ensured that the Best Ideas Competitive Edge portfolio avoided 90% of the loss that it would have suffered had a risk management strategy not been in place. 

This is a textbook example of why we view risk management as a critical part of our investment process and an essential tool for protecting client capital.

The same manager also submitted a 13D filing for Stock B.

This is a good reminder that risk management isn’t free. Sometimes a prudent approach to risk management results in an opportunity cost. Our risk management strategy prompted us to sell the stock at $61.95. This resulted I in a -5.67% loss or an overall portfolio impact of -0.17%.

Since then, Stock B has gone on to post performance of +26.89% (23/8/2019). We estimate the opportunity cost to be -0.82%.

Whilst Stock B’s exceptional return in this scenario is enticing, it is important to remember that such scenarios are exceptional and should not inform the basis of any risk management framework.

The above chart is taken from The Agony and the Ecstasy – The Risks and Rewards of a Concentrated Stock Position, by J. P. Morgan. It shows that the median stock under-performed the market (Russell 3000 Index) by more than -54%. Two thirds of all stocks on the Russell 3000 had negative returns from 1980-2014. Even in the midst of an economic expansion, 40% of stocks listed on the Russell 3000 experienced permanent catastrophic declines of 70% or more from peak value.

Extreme winners, or stocks that generate lifetime returns well above average are extremely rare, accounting for less than 7 percent of the performance of the Russell 3000 Index from 1980-2014.

Moral of the story? History suggests that when a stock experiences a sudden drop in price, the odds are that the fall will continue.

We define the challenge of investing this way:

“Making decisions in the face of uncertainty, on the basis of incomplete information where the consequences of those decisions may not be known or understood for a long time.”

We use risk management strategies because we recognise the inherent uncertainty of investing. We can’t control our profits, but we can control our losses. This is all the more important as losses occur more frequently.

190 views0 comments