Looking to Really Diversify Risk? Many people talk of diversification but if you want to really diversify risk, you need more tools. Here is an explanation of some of those tools…
Risk management in the investment field comes in many shapes and sizes. Oftentimes however, the type of risk being reduced is not exactly what the client wants. And because of this, it leaves the client open to other risks.
Want Less Risk? Need More Tools
I am going to make the point that although many people today are doing all kinds of things to reduce risk, they miss some very effective risk reducers when managing their portfolios. This article is especially important to those responsible for overseeing large endowments, pensions, charitable funds and private trusts. Why? Because you likely get pitched on some standard risk reduction techniques but you might not be using some more effective strategies.
First I will cover a sample of the common risk reduction techniques popularly used and the risks they attempt to mitigate. After that, I will delve into other more serious risk reduction strategies. Note: I briefly discussed this same topic on my personal blog ChrisGrande.com. However, this article here presents a more detailed follow up to that article.
Common Risk Management Strategies and Their Purpose
If you watch any amount of financial TV or read mainstream financial news publications you have likely heard the saying “diversification is the only free lunch on Wall Street.” What that means is that diversification – the idea of not having “all your eggs in one basket” – is something anyone can do. However, The particular risk addressed by stock diversification is individual company risk. In other words, this strategy will help prevent a portfolio meltdown potentially caused by having too large a position in one stock that blows up.
However, this often does nothing to prevent a 2008, 2001, 1987, 1976, 1974 etc type scenario where the whole market falls. Losing 40-50% might be ok for the individual investor who thinks they will “get it all back.” But for large money managers, these losses may prove unacceptable. Especially when there is a ~5% annual withdrawal commitment like with charities, endowments and pensions. Losses and withdrawals mix poorly!
Multiple Money Managers
Using multiple money managers as is often done with pensions and other large funds, helps reduce risk if each manager is managing using very different styles and tactics. Many think having a “large cap manager,” a “small cap manager,” a “foreign large blend” manager etc diversifies enough. But today with most markets much more correlated than before, and with the entire world hanging on the decisions coming from the Federal Reserve, the strategy of diversifying by company size or geography loses effectiveness.
The old standby is 60/30/10. A portfolio of 60% stocks, 30% bonds and 10% cash would earn a decent return at a level of risk that would comfort many. And oftentimes, this can be quite true. Especially back when cash paid 3-5%, quality bonds paid 6%+ and stocks had reasonable multiples. Now cash pays nothing, neither do quality bonds, and stocks are a tad overvalued.
So what to do?
To Really Diversify Risk Learn Some True Diversification Strategies
Really Diversify Risk Strategy 1: Shorting
Shorting is a disciplined endeavor. Most people can not short stocks effectively, for many reasons. Here are a few:
- The market on average moves up making shorting swimming against the tide.
- The maximum one can earn on a short position is 100%. And the losses are infinite because a stock could theoretically rise to infinity! Inversely, many long managers make a bulk of their profits from a few positions that rise 100,200,300% or more. This is impossible for the short manager)
- Short sellers have to pay dividends on stock they short. And incur other possible costs.
However, with that said, shorting is an excellent diversifier. It’s completely logical. In a bad market, short sellers are going with the tide. The key is, to work with an experienced short manager. A few can make money in all markets because there are almost always bad companies declining in price in the markets (Enron is a famous historical one featuring malfeasance), but few managers are this good. If a manager can squeak some small profits in regular markets and be there to make a killing in bear markets and crashes, then that is solid diversification.
Really Diversify Risk Strategy 2:”Trading” vs “Investing” – Trading Strategy Funds
“If I don’t control the cash flow, it’s not an investment, it’s a trade.” ~ me
My point? People say they are investors. But if you have no control over the cash flow decisions, you’re not an investor. Just a casual observer. And the line of thought that says “you own a little piece of a real business” – BS in my mind. Nonetheless, if you have multiple managers who are all researching individual companies fundamentally and making decisions that way, there is no style diversification. Therefore, adding a firm that trades, mainly on price/behavioral patterns, could be a diversifier.
Typically trading firms use futures to trade all sorts of markets. Trading stocks, bonds, commodities, and currencies. And trading long and short. Since trading decisions are based on price and trends (which typically reflect behavioral patterns in humans), and not on fundamentals, you can attain some real diversification and even profit in down markets as trading firms may be short.
Really Diversify Risk Strategy 3: Options Strategies
Option strategies run the gamut from higher to lower risk. One of the lowest risk strategies involves increasing portfolio yield for a buy and hold portfolio. A covered call strategy describes selling call options on stocks you own. With the idea that they will never be exercised, and collecting the premium. This thereby creates an income boost to what is typically a dividend focused portfolio.
By doing this, one could increase the yield on a portfolio from the average S&P dividend of 2% to something closer to 4-6% or more! Having a fat yield can certainly help in falling markets keeping the drawdown smaller and the portfolio return smoother.
The main risk of this strategy is having someone call away your stock and limiting your profit. I like this technique especially in extended markets (markets that are far above their moving average) when having the stock called away might be a risk management tool in and of itself. In a falling market, the option will become worthless allowing you to keep the premium. As I mentioned, this could be a good “overlay” strategy to a buy and hold portfolio or a strategy all by itself! The portfolio may realize the benefit of smoothing returns with extra income.
Really Diversify Risk Strategy 4; Deep Value
This isn’t so easy anymore. but deep value buying was one of Warren Buffett’s favorite techniques when he ran his partnership and earned big returns. As many don’t realize, Buffett wasn’t always “grandpa buy and hold.” He was what I would consider a trader. Merger arbitrage and the strategy of taking big stakes in a company until value is realized and selling constitute forms of trading in my opinion.
Maybe the decision dynamics were fundamental in nature. But he was still cycling through positions. And he certainly wasn’t abiding by his famous comment “Charlie and my favorite holding period is forever.” Nonetheless, using his strategy, he often had up years when the market was down.
Deep Value investing may provide a good diversifier to a high flying fund as a deep value manager often buys stuff so cheap it may not go down much more! (ideally of course and historically in the best case scenarios).
Really Diversify Risk Strategy 5: Currency Strategies
In my blogpost on ChrisGrande.com, I mentioned currency trading. However, since most of the world rocks and sways from Federal Reserve policy, it has become less dynamic in my opinion. Though in fairness, we had some great currency trends in the past few years. The Yen in recent years, the Euro for a number of years, the Yuan too. A currency only fund could be a diversifier. Though in the major countries, the stock markets tend to react strongly to the same government influences that are affect their currency.
The Really Diversify Risk Conclusion
If you are in charge of financial decisions for your organization (or your family), and risk management is important to you, then consider auditing the risk exposure of the money under your care. To which risks are you more susceptible? And furthermore, which risks can you mitigate? Sometimes there are risks you can not fully reduce and for some people (especially in the wealth building stage) who don’t want to reduce risk, because holding more risk potentially brings the big profits.
However, in my experience, clients with larger net worths don’t want excessive risk. And neither do the larger money funds which are responsible for funding charitable gifts or maintaining universities etc. If you think the time is right to reduce risk, do a risk audit and let us know if we can help.
Thanks for reading!