Risk Management

One of the most pervasive – and in our view dangerous – misconceptions about risk is that investors should allocate significant amounts of portfolio capital to non-equity holdings, such as bonds and gold. Traditional asset allocation strategies of the kind favored by most investment professionals may create a sense of comfort, but feeling safe comes at a very high price; holding lots of bonds, cash, gold, and other non-equity assets is nearly certain to cause serious damage to returns over time while doing little to reduce long-term risk. The bottom line is that, over long periods of time, stocks have outperformed every other asset class, and one of the riskiest moves a long-term investor can make is to hold anything other than stocks except in the most extreme (and infrequent) situations.

Given the weight of historical evidence demonstrating that stocks are indeed the best asset class to own for the long run, we approach risk management as a function of our benchmark, the S&P 500 total return index. From this standpoint, the least-risky portfolio is simply an index fund that closely tracks the benchmark and reinvests all dividends; the most-risky portfolio is one that consists of cash and other non- or inversely-correlated asset classes. Of course, we earn our fees in part by delivering long-term performance that exceeds the benchmark, and to accomplish that we make periodic adjustments to our style and sector weightings, and also introduce modest exposure to foreign equity markets when our analysis points to the merits of doing so. These weightings are an expression of our confidence in the quality of our analysis, but we are always mindful of the fact that anyone – including us! – can be wrong. Hence, allocations are carefully controlled relative to the benchmark to ensure that if one or more of our views is wrong, we will not seriously unperformed the benchmark and have to take an unacceptable level of risk to catch up.

We eschew stock picking in favor of owning well-diversified baskets of stocks, such as low-cost index funds and exchange traded funds (ETFs). Not only does most of the research demonstrate that individual security selection plays a much smaller part in determining long-term returns than does asset class, style, and sector selection, over shorter periods of time, having too much exposure to a single company that blows up can cause significant damage to the entire portfolio. If Wall Street’s best and brightest couldn’t predict Enron, WorldCom, Tenant, and the many other major meltdowns in the early part of this decade that were attributable to company-specific circumstances like fraud, the odds are that we can’t either.

What about hedging strategies (such as selling covered calls, buying puts, etc.), or stop loss strategies? While we do not rule out using these methods in a limited fashion to help manage particularly difficult (and rare) market environments, it is our view that these kinds of strategies will badly hurt long term performance if used on a regular basis:

• The concept of always hedging a portfolio against large market declines has obvious appeal, but it is a bad idea. First, as we have already mentioned, stocks have outperformed every other asset class over long periods of time, yet by incurring the additional costs of hedging a portfolio, one is likely to reduce anticipated long-term equity returns to levels similar to those of fixed-income investments. Second, most people want to hedge their portfolios when the cost of doing so is highest – i.e., only after a major market decline has already happened. (If there is ever a time to hedge a portfolio, it is when everything looks great in the economy and the markets and put options premiums are cheap.)
• The problems with using a stop loss in a long-term oriented portfolio are manifold. First, contrary to what many believe, there is no evidence to suggest that the past movement of a stock has any statistically reliable bearing on its future movement; hence, there is no rational reason to think that a stock is more likely than not to perform poorly in the future simply because it has underperformed in the recent past. Second, most stocks tend to follow direction of the overall market, and as contrarian investors, we know that the market often displays above-average performance after most investors have already given up on it; a stop loss strategy could thus force the liquidation of multiple positions at the very time that one should be a buyer of stocks! Finally, stop loss strategies are almost certain to boost transaction costs and short-term capital gains taxes, which can be a serious drag on long-term portfolio performance.

The only time that we take the relatively rare – and risky relative to the benchmark – action of reducing or even eliminating equity exposure in our portfolios is when our analysis points to the high likelihood of a bear market – a sustained period of serious downside volatility. The good news is that big bear markets don’t come along very often. The bad news is that when they do, they wreak havoc on the long-term returns of those investors who try to ride them out. The reason is the perverse math of losses. Small losses require only slightly larger gains to get back to break even, but recovering from large losses requires exponentially-larger gains. For example, a of loss of only 10% (typical of many short-term corrections) requires a gain of 11.1% to get back to break-even – well within the range of what one can reasonably expect over the course of an average year in the stock market. But a decline of 50% requires a gain of 100% just to get back to even, the kind of return that typically requires a few years in even the strongest of bull markets. And if you are one of the countless investors who rode the Nasdaq down 78% from its March 2000 top to its bear-market bottom in October 2002, getting back to break-even requires a massive 350% gain – a wait of perhaps a decade, if not much longer, just to get back to square one.

Avoiding the worst losses in a bear market is thus crucial to preserving long-term gains, but it is not necessary – nor desirable – to try to get the timing perfect. The most damage almost always occurs in the second half of the decline, and, after the bear ends, the strongest gains are concentrated in the first half of the new bull market. Hence, the best strategy is to adopt a defensive stance a few months after a bear market has started (it is almost impossible to distinguish a real long-term top from a short correction without analyzing investor behavior and price action following the initial decline) and to get back in a few weeks before it ends (so as not to risk missing the very strong gains of the young bull market). Our goal is not to make money in every market environment, but rather to avoid losing capital in a calendar year in which stocks decline.

Specific tactics used by Financia Capital during a bear market may include writing covered calls (an options strategy that acts like an insurance policy for existing holdings), switching into inverse index funds and inverse ETFs (instruments that rise when the market falls, and vice-versa), buying selected fixed-income investments (such as Treasury notes and bills, GNMAs, and CDs), or even just holding cash until there is sufficient evidence that the bear market is bottoming out.