“Risk-Wise” Risk Management

The turmoil of the stock market over the last decade has forced professional and individual investors to refocus their attention on identifying, managing and mitigating as many investment-related risk factors as possible. Michael Carpenter’s book, “The Risk-Wise Investor” (Wiley, 2009), offers a look at the evolution of risk and how investors today should plan for and protect themselves from market risk. Carpenter has spent over 35 years in the investment business as a financial advisor. He urges investors to take an honest look at risks and to face them head-on instead of waiting until it is too late.

While developing and implementing successful trading strategies is important, managing your portfolio’s risk is equally as important. However, protecting your investments from downside risk does not have to be complicated and, according to Carpenter, can be very simple once you have the knowledge and tools.

Risk management is not a new phenomenon, but has received much press over the last few years. Carpenter argues that individual investors should employ risk management tools and ideas just as businesses and professional investors do.

He also believes that everyone has the ability, knowledge and experience to manage risk naturally. Carpenter notes that successful management of risk and reward happens every day and transferring this knowledge to your investment portfolios is not hard.

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Understanding Risk and Human Behavior

Risk Management Schools of Thought

Carpenter contends that there are two major approaches to managing risk: the quantitative approach and the qualitative (or subjective) approach.

Quantitative Approach

The quantitative approach was first used to calculate the probability of chance events and also includes the concepts of the bell curve (normal distribution of returns), regression to the mean and risk/reward trade-offs. More recent contributors to the quantitative approach include Harry Markowitz and the efficient frontier, William Sharpe’s Sharpe ratio, the Black and Scholes options pricing model, the capital asset pricing model and modern portfolio theory.

The approach uses mathematical formulas to construct, monitor and rebalance portfolios. Data points such as alpha, beta and correlation coefficients are familiar to many investors. Historical data is used to predict future market movements.

The quantitative approach is the most widely used among investment professionals; however, its real-world applicability has been called into question. Quantitative market measurements use a number of assumptions that do not hold up in the real world. In stable markets the quantitative approach tends to work fine, but when the markets start behaving wildly, as they did in 2008, these theories are less translatable. Carpenter argues that it is during such market instability that investors need protection the most.

Qualitative or Subjective Approach

The qualitative approach focuses on ever-changing risk factors and situations. With this approach, risk/reward decisions should be made based on future assumptions rather than what has happened in the past. This more predictive approach may be hard for many investors to embrace due to lack of confidence in their own market forecasts. The qualitative approach is flexible and forward looking, while the quantitative approach is rules-based and relies on historical trends and data.

Risk Perception vs. Reality

According to Carpenter, humans in general tend to both overestimate and underestimate risks. Some common misperceptions include being more fearful of newer risks as opposed to established risks, being more afraid of naturally occurring risks as opposed to human-made risks, being less fearful of risks that have been self-chosen as opposed to those forced upon us by others, and being less afraid of risks over which there is perceived control. These perceptions generally lead to overestimating risks over which we feel we have less control and underestimating risks over which we feel we have some control, whether we actually do or not.

Another issue Carpenter addresses is the fluctuation of risk perceptions. As almost any investor can attest, when the market is going up, earnings are growing and overall business news is good, people are less concerned about risk in their investments. As market prices fall, perceived risk of investing increases. This can lead to buying in an up market and selling in a down market. Carpenter refers to Warren Buffett and John Templeton, who both employed a contrarian-type strategy that buys when people are selling and sells when they are buying.

Making Decisions in Uncertain Environments

In the past decade, the study of human behavior has leaked into the financial world to create behavioral finance. Carpenter discusses a few of the findings that relate to investment decisions in order to expose our natural tendencies and help us avoid making similar mistakes in the future.

One bias is making snap judgments that we find hard to change even in the face of contradictory information. Most people do not have a built-in monitoring system that implores them to double-check initial decisions and reconsider new ideas after a decision has been made. Carpenter believes having a process to review information and also someone to act as a sounding board when making investment decisions are good ways to attempt to overcome this human flaw.

Following the herd is another human phenomenon that can cause us to make bad financial decisions. In the investment world, so-called “hot stocks” may have their prices bid up due to increased investment by institutions, individuals and professionals. As more people buy into the stock, the price rises. Investors (and sometimes pundits) take this as a sign of guaranteed future performance because the stock’s recent price performance has been good. The reality is that the price might be inflated due to the upward pressure from all the buyers. By following the herd, you are buying into an overpriced stock.

The “Greater Fools” fallacy builds on this and says that even though investors might know the decisions they are making are foolish, they are hoping that someone else is even more foolish and will buy their potentially overpriced stock at an even higher price. In this context, it is easy to see that this “house of cards” is riddled with problems.

Finally, Carpenter discusses extrapolation or extension biases. This is simply the tendency for investors to believe that what is happening right now will continue to happen: A stock that is rising in price will keep rising, or a company that is consistently beating the consensus earnings estimates will continue to provide better-than-expected results forever into the future.

On the flip side, as the market falls, investors tend to believe that the slide in prices and stock values will continue. Carpenter concludes that, in addition to protecting our investments against outside risk, we need to understand and protect our investments from internal risks as well.

The “Risk-Wise” Approach

Armed with information about the risk management schools of thought and the flaws in risk perception and human behaviors, Carpenter introduces us to his “Risk-Wise” Risk Management approach, which has five steps.

Step 1: Personal Risk Assessment

Carpenter points out that the types of risks we face every day change over time. We face such a multitude of risks when it comes to investing (company, management, economic, regulatory, inflation and general market risk, to name a few), that it is nearly impossible to worry about and mitigate them all. We also have finite resources (time and money) to devote to risk management, making these next steps important. He believes investors must decide which risks are worth focusing on and which can be ignored.

Defining Risk

Carpenter counsels that your basic definition of risk is a critical foundation on which your entire risk management approach is based. When defining risk, most people discuss the outcomes of risky situations (i.e. losing money, performance below a benchmark and market volatility). Defining risk in this manner places weight on random outcomes over which you have little or no control.

For a more personally empowering definition, Carpenter turns to Apple CFO Peter Oppenheimer, who defines risk as “the degree to which an outcome varies from expectation.” From this definition, we see that while risk is based in randomness, we do have some control in the form of forecasting and anticipating the risks. Instead of feeling like everything is left to chance, we can attempt to forecast various scenarios for the future. The more realistic our expectations, the fewer surprises we may encounter.

Identify Risk

Depending on your investment type (individual stocks, bonds, exchange-traded funds, or mutual funds), your list of risks will differ. Carpenter encourages readers to list any and all risks that come to mind, both in and out of your control. He uses examples like recessions, deflation and liquidity. Risks outside of individual security risks should be included as well—for example, the risk that you will not have enough money for retirement. While it is at times uncomfortable and scary to think about the terrible things that can happen to your investment portfolio, it is vital to be realistic about them so you can attempt to mitigate some of the risks.

Understand and Prioritize Risk

After you have identified risk factors, you will need to determine the likelihood of the event actually happening in the next five years. Carpenter suggests labeling risks as high, moderate and low, but you can use any type of ranking system you see fit.

Next, rate the level of personal impact for each event. Again, Carpenter uses the ranks of high, moderate and low. For example, the risk that you may not have enough money for retirement is perhaps moderate, but the personal impact would be extremely high.

After you have labeled each event with the likelihood and the personal impact, you are ready to prioritize your risks.

A common misstep in prioritizing risks is to place more importance on higher-frequency events, no matter their level of impact. Carpenter points out that doing this means you will spend too much of your finite resources fighting the same inconsequential fires while leaving yourself ill-prepared to cope with high impact events (for example, the market downturn in 2008). He suggests ranking risks by severity, or level of impact, then probability.

High impact/high probability risks should be viewed as imminent and steps should be put in place to mitigate these risks as well as measures taken to reduce the likelihood of the event happening (if you have control) and the recovery time needed if the event should occur. Going back to the example of money required for retirement: You can re-budget and sock away more money now, or diversify your current holdings in order to mitigate this risk. On the flip side, a recession or market sell-off is not under your control. In this case, you cannot do anything to prevent it from happening, but you can devise a plan to deal with the situation should it occur. Planning what to do in advance can help keep your emotions out of the decision process.

Because you have finite resources, it is inevitable that you will not be able to mitigate and plan for all your listed risks. You will have to decide which risks to ignore or devote fewer resources to. The low impact/low probability group should be the easiest group to set aside. Carpenter advises that the key is to have a plan in place to handle those events that will have the largest negative impact on your investment portfolio.

Black Swans

As we have recently seen, very rare, high-impact, sudden and unexpected events—black swans—can wreak havoc on the stock market and our portfolios. Carpenter believes that even though by definition black swans are unpredictable, they are increasing in number and in level of impact. He points to the terrorist attacks in 2001 as well as the housing market crash and the global recession in 2008 as examples.

While it is impossible to predict these events and their impacts, Carpenter says the most important thing investors can do is to keep their heads when they do happen. He refers back to the perceived risk discussion and the tendency to follow the herd. The best way to handle such an unlikely event is not to make sudden decisions based on fear or confusion.

He also suggests setting aside a portion of your portfolio for purchasing stocks that have dropped in price due to market pressures. While you may benefit from underpriced securities, you may also benefit from a more controlled emotional reaction to such events.

Step 2: Choosing a Risk Management Strategy

Once you have decided which risks you will focus on and which you will ignore, Carpenter discusses some risk management strategies. Each risk may have a different risk management strategy depending on the type of risk.

Passive Risk Management

Investment time is the simplest way to mitigate some risk according to Carpenter. A number of studies have shown that the longer you have money in the market, the less probability of a negative long-term return. Carpenter points to studies that show that with a holding period beyond 20 years, there are no historical periods that long-term investors had negative returns. This is a fairly obvious strategy, but some investors find it difficult to stay in the market during bad times.

Broad diversification is another passive risk management strategy Carpenter explores. First, you should start with an overall asset allocation that establishes your risk level (bonds versus stocks versus cash). Next, your allocation to stocks is divided into international and domestic groups; then into market cap and investment style groups. A portfolio should be rebalanced regularly, but not too often, to maintain the desired allocation.

Morningstar.com offers a portfolio management tool with numerous allocation and diversification tools (www.morningstar.com). The X-Ray tool (shown in Figure 1) allows you to see how your portfolio is allocated based on asset class, sector, style, stock type and geographic location. After you have entered your holdings into the Portfolio Manager, you can use the Premium X-Ray tools, which cost $174 per year.

Each X-Ray allocation tool includes a detailed breakdown of holdings. For example, the Stock Sector X-Ray page lists the percentage of holdings in each sector and compares it to the S&P 500. You can also see how individual holdings are classified.

The Asset Class breakdown shows the percentage you hold in U.S. stocks, foreign stocks, bonds and cash. The Stock Stats X-Ray tool classifies holdings as high yield, distressed, hard assets, cyclical and slow, classic, aggressive and speculative growth. Finally, the Stock Style X-Ray uses Morningstar’s style classifications of large-cap, mid-cap or small-cap, and value, core or growth.

For more information about portfolio asset allocation and portfolio building, visit AAII’s Portfolio Management area of AAII.com, especially the Portfolio Observer (www.aaii.com/ppo).

Active Risk Management

There are numerous active portfolio strategies for managing risk, and Carpenter touches on a few in minimal detail. Technical analysis relies on charting to identify trends in stock and index prices. Using breakouts to decide when to buy and sell can be time consuming, but can help keep emotions and human fallacy out of the decision process.

Market timing involves attempting to buy when prices are low and sell when prices are high. While this seems like an obvious strategy for any investor to follow, it has proven difficult to implement successfully over the long term. Again, this strategy takes time to decide at which prices you will buy and sell and discipline to enact the strategy.

Carpenter discusses various hedging strategies including using options to mitigate downside risk or create additional income. Cash hedging is another strategy used by investors who believe that the market is highly cyclical. Based on the theory that every four or five years there is a market drop of at least 20%, the strategy is to sell some or all of your securities and raise cash once the market has advanced for three or four years. Investors will then have cash on hand when the market makes its inevitable decline, and they can purchase stocks whose prices are depressed.

Finally, gold and precious metals are often used as hedges. You can now invest in these via exchange-traded funds ETFs, mutual funds or even stock of companies that have a stake in the precious metal markets. The gold and precious metals industries tend to be counter cyclical to the overall market. When the market is losing, gold and precious metal prices tend to rise.

While such active risk management strategies sound good on paper, they require a level of investing savvy that many individuals lack. As part of your risk “self diagnosis,” it is also important to realistically assess your abilities as an investor to implement some of Carpenter’s risk-management solutions.

Step 3: Evaluate Risk/Reward Trade-Offs

Carpenter describes this step as involving a double-check of the decisions made so far. Have you thought through all the possible outcomes of each strategy? Be sure you have. Are you falling into any of the decision traps discussed earlier? If the answer is no, then you can make and implement decisions.

Step 4: Decide to Act or Not Act and Implement the Decision

If you are comfortable with your decisions and feel the process was correct, Carpenter allows that you can proceed to implement your risk management strategy.

Step 5: Risk Monitoring and Decision Making

After the decision is implemented, Carpenter advises that you will need to continue to monitor your risk levels. Adjustments and corrections will likely be needed as your financial situation and your risk profile change. Carpenter also suggests that you regularly update your risks and reprioritize them. If there are any new risks that need to be managed, go to step two and decide how to best do that.

Conclusion

While at times it seems picking appropriate securities for investment is the toughest part of successful investing, preparing your portfolio for the worst-case scenario outcome can be extremely difficult. However, it is a very important step in reaching your investment goals. If the recent market has shown us anything, it is that you will need to expect the unexpected, and that risk is inevitable. Preparing for and managing risk is the best way to avoid a portfolio meltdown. Michael Carpenter suggests one approach that may be worth consideration.