04/21/2013 Managing Risk

Sector Model	XLB	0.88%
Large Portfolio	Date	Return	Days
BBRY	7/16/2012	90.90%	279
SEAC	9/25/2012	33.17%	208
CAJ	9/25/2012	10.32%	208
BOKF	2/4/2013	10.54%	76
SWM	2/12/2013	8.68%	68
GMCR	2/19/2013	23.92%	61
OKE	2/25/2013	8.31%	55
TTM	4/1/2013	6.55%	20
MWW	4/11/2013	-4.46%	10
ABX	4/11/2013	-25.72%	10
S&P	Annualized	7.97%
Sector Model	Annualized	22.99%
Large Portfolio	Annualized	30.14%

Rotation: selling GMCR; buying TPX.

What an evil week. 

Steven Pinker wrote “The Better Angels of Our Nature” to show how violence has declined over the centuries, and even during our lifetimes.  He makes a compelling statistical case, but it’s no help in an age of instant communication.   Statistics don’t make you feel much safer, when you see a week of bombs, poison notes, and a plant explosion.

The most dangerous animal you’ll ever meet is a human being.

But… back to statistics (and the subject of this blog).

After Friday the model estimates a 100% bullish bias for the broad market over the next quarter.  For what it’s worth, every timing expert I respect is bearish.  So if my model is wrong, it’s as wrong as possible. 

And that brings me to the question of risk.  Most folks try to manage risk through Beta, Hedging, or (infinitely worse – letting their fear and greed “time” their portfolios into oblivion).

Beta creates risk by scaring investors.  By itself it does nothing.  Higher Beta is usually associated with smaller caps, which outperform large caps.  However, within the same capitalization levels lower Beta is associated with better returns.  If you’re going to try to do something with Beta, you have to measure it as a ratio of capitalization.  My own model sees little to no value in Beta, but that could just be a quirk of the model.  In the investing world, the Capital Asset Pricing Model tries to get the most return for the least risk, and hedge funds are often evaluated by a model developed by Fama.  Both of these want the greatest return for the least risk, and while there are reasons for them to do so, those reasons do not translate well for a personal investor.  The actual purpose of these models is to maximize the amount of margin that can be used and to lose the least amount of clients.  A hedge fund is ultimately in the business of managing assets, and scaring clients on the way to the best possible returns will not help their clients or themselves.

So, they hedge…

Hedging manages risk by lulling investors to sleep.  By itself it actually reduces returns because it works against a long term 8% annualized positive bias in the market, and charges traders shorting costs on top of it.  Even worse, if you’re right you can only gain up to 100%, but if you are wrong you could lose MORE than 100%.  A hedge fund can do it (most can’t, but some can), but practically no individual is equipped to do this for themselves, nor do they have the time to sit staring at their computer screen all day.

Ignoring Beta, Hedging, and Timing, what does that leave for a person trying to invest for himself in a personal IRA?

Two things, and only two things:

1) Time

2) Position size

I have a friend who was in the emergency room for one day, then in the hospital for another, and when he got out two days later he had lost 80% of his retirement – because he was using heavy margin while day trading.

Basically the larger your position size, the shorter amount of time you have.  And normally you’ll be wrong on occasion and will be forced to sell at a loss.

And you only have to be wrong once.

My own model invests no more than 10% in any single stock.  Any time I’ve violated that 10% limit in the past I’ve lost money because I was forced to sell at the wrong time.

And I mean that I sold at EXACTLY the wrong time.  I am uncanny in my ability to create the worst possible time decision when working from instinct.  And any position size greater than 10% will pull that instinct out of hiding and ruin my day.

Think of any position larger than 10% as a clear and present danger.  You can be right ninety-nine times in a row, and wrong the hundredth, and you could lose everything.  You’re like a gambler at a craps table, letting everything ride over and over and over again till you have an insane amount of chips on the table and you cannot make yourself stop.

But once you lose, the table makes you stop.

We do the same with the market, much more likely to sell for a 15% loss than a 15% gain.  Or worse, to hold for a 75% loss instead of a 75% gain.  If the position is only 10% of your portfolio, you can wait until you have the right sell point.  If it’s any larger, you’re trapped – glued to the screen – losing sleep over any potential tick of the market that goes the wrong way.  And then you’ll close the position and watch the market INSTANTLY reverse in your favor.  But you aren’t there any more to reap the benefit.

THAT’s risk.

In fact, it’s even worse than risk – it’s practically a guarantee that you’ll lose.

So, on the long side, time is your friend.  But if you are heavily margined or are too heavily invested in any given stock, you won’t be able to wait for the right time to take a profit.

10%.

No more, in any given stock.

Period.

Tim