Commentary
“Risk management is the bedrock of our firm” is often a line you hear when managers or advisers talk about their strategy and approach to the markets. What you rarely hear is an in depth explanation of what that supposed bedrock is actually made up of. What is the actual process a manager goes through in assessing all of the perceived as well as potential unperceived risks in a particular investment or strategy? What does it mean to manage risk in real time? Do you manage risk for individual positions or the entirety of a portfolio?
When I talk to new traders or managers about risk management I want to know how they think about taking losses. For me a firm understanding of the fact that loss taking measures aren’t just prudent but a necessary ingredient to a successful plan. Furthermore I would argue this is agnostic to time frame. If you are managing positions for two minutes or two decades you must have a process to determine when you are wrong and going to take a loss. This should be the first lesson a registered financial person in training should have to take. Something to the tune of “Taking Losses 101: How to Live to Fight Another Day.” Some day I may try and teach such a class, but sadly this is precisely the opposite of what most learn when going for their different financial designations.
I once had lunch with the head of a large wealth management firm in the area near where I live and after exchanging pleasantries we started speaking more candidly about what we did and how we thought about markets. To my surprise this individual didn’t seem to have any real knowledge of how to manage risk for his clients at all, at least not with respect to loss taking.
“We rely on our 60/40 portfolio construction to help weather any really bad storms in the market,” he stated. “We’ll do a little tax loss selling here and there to help offset other gains, but we like to stay invested for our clients.”
I asked about what would happen in the event that bonds and stocks both fell and he said that generally wasn’t much of a risk. The conversation really ended with regard to risk right about there as in my view there wasn’t much more to talk about, at least regarding risk management. He had found the goose that laid a golden egg whereby he’d never have to think about the downside because he had something to lean on—in his case, if stocks went down, bonds went up, and so on.
Fast forward to the end of Q1 2022 when bonds had one of their worst respective starts to the year in decades. Not to worry if you have such a strategy as I’m sure your stock portfolio more than pulled the weight of the losses in bonds, but wait—the volatility and decline in risk assets hit stocks as well. What is going on here? I thought these two pulleys were reflexive—if you push one down the other goes up and vice versa.
The reality is this: There is no rule written anywhere that states one asset is required to move in a certain way relative to another asset. Markets are driven by buyers and sellers and at the end of the day people can be enticed, coerced, or even forced to buy and sell for many different reasons, and more theoretical reasons than even the smartest manager could ever hope to model.
These type of risk parity strategies are nothing new and they are not necessarily flawed. The devil, as always, is often in the details, or in this case, the risk tails. In a classic bond/stock portfolio construction, the model is simple and generally works to try and provide slower and steady returns. So the question ought to be how bad would, or will it be if they both fall precipitously? What does a really bad risk tail type event in the probability distribution for this strategy look like? This type of questioning generally doesn’t even happen. Worse yet, when it does it goes ignored as an improbable outlier.
I am not suggesting that all forms of risk parity are necessarily bad, however I think the idea of risk parity is potentially misguided at its core. Taking the prior example of the classic stock/bond portfolio in most years, this strategy yields marginally decent returns with lower volatility and just seems to eat away like a bird. The problem of the tails happens when a bear market for both assets are coincident, you get a portfolio that eats like a bird for a decade until it excretes like an elephant. This in and of itself is painful, but when understood can potentially be weathered or accounted for ahead of time. The problem is when people don’t understand it, come to rely on it as axiomatic, or worse yet apply excess leverage to it. When leverage is applied to these type of risk parity strategies the blow ups are spectacular, Archegos in 2021 being the most recent in a long list.
The most simple form of risk management is not finding an inversely correlated asset that I can use to lay off the risk onto, it is simple position cutting. If you own something and you feel it is too much risk, the safest thing to do is sell all or a portion of it until you are comfortable with the risk you hold. I am continually amazed at how this simple truth evades some of the smartest people. I would challenge the reader to become an expert in understanding risk management in its simplicity. Complexity is often overrated, and when it comes to risk management it can be deadly.
