Risk Management: No Free Lunches

When it comes to investment strategy, our mantra is “On average over time, NOT every time”.

History tells us that risk management reduces risk and preserves capital in the long run. Unfortunately, these benefits don’t always hold over shorter time horizons. When managing risk, an understanding of the trade-offs associated with risk management is paramount to setting realistic expectations for future investment performance.

Stop losses are an important risk management tool, however they’re not free. In the long run, risk management helps to create a positive asymmetry between winners and losers. No investment strategy can work all of the time, risk management is no exception. A risk management strategy that effectively limits losses in the long run often comes at the expense of selling stocks that go on to recover and become winners.

In a bear market, the payoffs from risk management are realised almost immediately. There is a positive relationship between the payoffs from risk management and the magnitude of a sell off event in the market. However, as the time old investment metaphor that there are “No Free Lunches” implies that limiting our downside involves a cost; a cost that’s incurred in years where the majority of stocks are rallying.

2019 has been a year characterised by positive performance across the vast majority of stocks and limited losses amongst those that performed negatively.

The chart below shows the ratio of S&P500 stocks that have posted positive returns greater than 10% for the year versus stocks that have posted negative returns of - 10% or worse for the year. Currently, this ratio stands at 8:1. That is, there are 8 times as many stocks with a +10% or better return as there are with a -10% or worse return. This is both double median ratio (4:1) and higher than the 75th percentile return ratio (5:1)

Ratio of S&P 500 Stocks with Returns of +10% p.a. or Better vs 10% p.a. or Worse

A stop loss strategy is likely to be more costly in periods where eight times as many stocks have positive returns instead of negative returns

Periods of sustained positive returns (like 2019) affect our risk management strategy in two main ways:

  • Stop losses are not nearly as likely to be triggered

  • When a stop is triggered, there is a higher likelihood of this being a false positive rather than a false negative.

In this context, a “false negative” occurs when a stock is stopped out prematurely before going on to recover and then rally.

However, it is important that we’re not fooled into accepting years like 2019 as our base case for risk management. See the years highlighted in green in the chart above (1999, 2000, 2001, 2002, 2005, 2007, 2008, 2011, 2015 and 2018). In these years, far fewer stocks returned performance of +10% or greater. In these years, risk management is not only more likely to reduce risk but may also improve investment returns.

Below is a chart showing the percentage of S&P500 stocks that experienced a loss of -10% or worse during a given year. 2017 was a year distinguished by all-time low levels of volatility, during this year, the percentage of losing stocks was 11.7%. This year, only 9.2% (i.e. less than 50) of stocks in the S&P500 have lost -10% or worse. By comparison, over the last 20 years, the median percentage was 14% of stocks and the 75th percentile was 37%.

Percentage of S&P 500 Stocks with -10% or Worse Returns

To put these numbers into perspective, focus on 2018, a year where almost 50% of stocks suffered a loss worse than -10%. Limiting losses with risk management in 2018 would have improved returns.

Based on the almost 21 years of S&P500 performance examined above, we can draw the conclusion that risk management helps in approximately 50% of the time. It is of little benefit and may act as a drag on returns when most stocks are doing well. 2019 is a reminder of this. It also hasn’t helped the stock market has been “choppy” for most of the year. But this won’t always be the case.

One way to better understand risk management is to look at its application in other areas e.g. the sporting world. In the game of cricket, a nightwatchman’s is a lower-order batsman whose job is to maintain the strike until the close of play. Their role is to protect other, more capable offensive batsmen from being dismissed. What the humble nightwatchmen may lack in run scoring performance in the short run, they more than make up for by providing a strategic advantage to the top-order batsmen in the long run.

The key to understanding the worth of a nightwatchman is to focus on the batting line-up (as opposed to an individual player) and the full five days of play. Likewise, the key to investing is to focus on your entire portfolio (as opposed to an individual stock) over a long-term time horizon.

The runs sacrificed by playing nightwatchmen allow the big hitters to start the next day refreshed and ready to face the opposition bowling attack.

Cricket, like investing exists in a world where we are forced to make decisions in the face of uncertainty, on the basis of incomplete information. Where the consequences of such decisions may not be immediately known or understood.

We use risk management strategies because we recognise the inherent uncertainty of investing.

71 views0 comments