How to Manage Risk in Your Portfolio
There are many strategies for making money in the market. Very few of them work all of the time. Put another way, the vast majority of them work almost none of the time. Or, to put it still another way, many of them work…until the time comes when they don’t.
Of course, we only know which ones don’t work (or, more precisely, when exactly they stop working), with the benefit of hindsight. It’s all well and good to advocate a healthy skepticism toward loading up on toxic, mortgage-backed securities (MBS) now, for instance. But before they blew up in 2007-’08, too few investors even realized that skepticism was healthy. Investing in MBS made a few people very rich…until it made a lot of people very poor.
One investor who did warn (and quite loudly) about the build up of excessive debt and the increasing complexity of a derivative-laden system was Nassim Nicholas Taleb, author of Fooled by Randomness, and, later, The Black Swan. Taleb specializes in what he calls “low probability, high impact” events; events such as those the financial world witnessed during and after the collapse of Lehman Bros., a seemingly rock-solid institution that had survived the Great Depression and a couple of World Wars before a series of apparently “mathematically implausible” events conspired to take it down.
Of course, few listened to Taleb before the events he predicted took place. More strikingly, the remedies he publicly advocates were not only NOT implemented in the wake of the crisis but, in many cases, the exact opposite course of action was prescribed. The US system now has vastly more debt than when it started – and a lot of that new debt hangs around the necks of taxpayers. Meanwhile, most of those individuals who are most responsible for creating the crisis remain in critical decision-making positions. And that’s to say nothing of the increased scope and power subsequently granted to the embarrassingly inept regulatory bodies…but that’s a subject for another day.
It could fairly be argued, therefore, that there is far more reason to be cautious today than there was even before the crisis began. The optimistic corollary to this grim assessment, however, is that, historically speaking, periods of extreme volatility often produce highly profitable opportunities. It’s just that the rewards tend to be concentrated around a much smaller group of investors…investors who took the “other side” of the larger group’s insane bets. When markets are calm, the majority of investors generally muddle along, making “OK” returns and sleeping pretty well for it. The big money is often made during what is sometimes referred to as the “mania” stage of the cycle, when prices reach mega-bubble proportions on the way up, and burst spectacularly on the way down.
In such an environment, it probably doesn’t hurt to learn a little from Mr. Taleb, a man who specializes in “expecting the unexpected”…or at least attempting to prepare for it.
Taleb has long been advocating what he calls “The Barbell Strategy.” He explained his thinking, once again, at The Russian Forum Debate earlier this year, where he appeared alongside Dr. Marc Faber and a host of other “doomsday” investors.
Put simply, Taleb suggests allocating the majority of your portfolio to low-risk or “no-risk” investments. (“No risk” investments imply using options to hedge against even incremental moves in the market, much like putting a dollar on red and a dollar on black at the roulette wheel. In reality, of course, there is no such thing as an absolute “no risk.”) This, he says, is primarily for the purpose of capital preservation.
The smaller portion of your portfolio (and exact ratios will differ from one investor to another), according to Taleb, should be at “maximum risk.” These are the kind of investments that, as he explains, “I know I’m going to lose money on…but boy, if you get it right, it’s going to be big.” The kind of speculative plays where, if you are on the money, “you’d never see a public [commercial] plane again.”
In other words, as the theory goes, you want to expose a small portion of your portfolio to the maximum upside potential of “low probability, high impact events” – those events Taleb refers to as “Black Swans” – while protecting the majority of your portfolio from the associated downside risk.
As Doug Casey, founder of Casey Research explains, “Most people invest 100% of their capital in hope of a 10% return. I prefer to wait until I can invest 10% of my capital for a 100% return.”
Speculating, it is important to note, is not the same thing as gambling. “They’re very different,” says Doug. “Speculation is the art of capitalizing on politically created distortions in the market.”
As individual investors, there’s little we can do to influence the level of risk in the overall market. After all, politicians will be politicians and their decisions, boneheaded as they almost always are, will usually reflect that. We can, however, manage the risk within our own portfolios, both to protect our capital and, with a bit of luck, help it grow.
Regards,
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