With that said, managing volatility is risk management. It’s a term on Wall Street that is too often overlooked and taken for granted. Most investors have no idea that their portfolio managers have weak risk-adjusted returns. Most investors are unaware of the fact that most portfolio managers take unnecessary risks and manage portfolios not for client returns, but for the institution they work for. Risk management is important because the trek to the top of the investment mountain is fraught with risks.
I’m not pessimistic by nature. In fact, I am quite the optimist. But I view the trek up to the top of the investment mountain as being full of risks. Seeing butterflies and rainbows sure make the trek more enjoyable, but won’t guarantee that you ever get there (just ask the millions of baby boomers who have been fooled by the myth of buy, hold & hope!). Anyone can get caught up in the beauty and wonder of a butterfly or a rainbow (or a bull market!), but it’s the cautious observant who steers you clear of the loose rocks and the avalanche attached. If you don’t watch out for potential pitfalls I guarantee that you’ll never get to the top of the mountain.
Risk management is about identifying potential problems and positioning portfolios so that the effects of those problems are minimized. Understand, that you are going to run into loose rocks along the way up the investment mountain. There is a tendency to punish everyone in the investment world who is ever wrong. Some people take great pleasure in trying to prove that other investors are just as bad as they are. The truth is, we all make mistakes, but some people prepare for it and others don’t.
Some investors create flexibility in a portfolio by hedging positions. Others use multiple strategies. Others diversify (true diversification). Here are a few things that can help you create a flexible portfolio and hopefully avoid your own implosion or underperformance:
1) Always be flexible and never stay married to a loser. Never get married to a particular position or a particular strategy. The market is complex, dynamic and always evolving. Learn to change with it if necessary. No two investment environments will ever be the same so it’s not rational to believe that you have found some holy grail strategy that will never fail. A static approach will create losers and losers have no place for a portfolio. Cut your losers – even if it’s an entire approach.
2) Use multiple asset classes and create non-correlation if possible. This is why most investors fail in the market. They learn one strategy or one asset class and when that one approach stops working they’re a sitting duck. Trading one asset class with one directional bias would be like a professional baseball pitcher deciding to throw nothing but fastballs. You have many options and pitches – utilize them all. Learn to diversify your strategies AND investments. This might involve using multiple strategies (my preference) or it might involve using several different asset classes. You don’t have to pigeon hole yourself in this world. You can be flexible in this world. Take advantage of it. The greatest part about the mass financialization of our economy is that investors have choices now. Learn to reach into a different bag of tricks if you need to.
3) Don’t be emotionally biased. You might be trained to believe that buying stocks is the best way to invest in a market. You therefore ignore the other side of trades or other asset classes. This bias can lead to a permabull perspective (or a permabear perspective for the more pessimistic) or other extreme biases that make you susceptible to underperformance. Learning to be unbiased and flexible are perhaps the two most important rules to becoming a good investor.
4) Never stop learning and recognize that you know less than you think you know. The global economy is a great puzzle. To my knowledge no one has yet solved it. It is dynamic, interesting and above all else important. Understanding the entire system is vital to learning how to understand risk and better manage your money. Most investors think they understand investments by picking up a book about dividend paying stocks. But if you don’t understand how the global economy, currencies, and a multitude of other variables influence that stock’s performance you truly can’t even begin to fathom what risk management is.
5) Create rules within your approach AND FOLLOW THEM. Your strategies should not be rigid, but your implementation of them should be. Think somewhat like a robot when investing. Some strategies are literally automated, however, if you don’t have software or the knowledge to create automated systematic approaches you should still create rules that remove the emotion from your approach. This is no place for cry babies, excuses or arrogance. If you allow the market to do it she will break you down and she will humble you. Having rules will help you remove the emotion from your investment approach and help ensure that you don’t suffer catastrophic losses.
Do You Have a Good Cash Alternative Strategy?
After a full year of strong returns for almost all asset classes, investors have reason to feel uneasy. Since the end of January, market volatility has returned. Stocks and bonds both delivered negative returns in February, as concern over inflation intensified. Although holding cash appears to be the safest option, it is not a viable long-term strategy. This is especially true as an acceleration of inflation could erode purchasing power over time and guarantee a negative return in real terms.
At STA Wealth Management, we advocate a disciplined approach to buying and selling. The reason is that trading driven by “fear and greed” has not only proven itself to be fruitless, but also harmful to long-term financial objectives. As shown in the chart below, investors poured billions of dollars into SPY, an ETF tracking the S&P 500, during the January market rally (greed behavior). Then the sharp decline in the market caused investors to quickly pull money out, right before the index bounced back (fear behavior).
But who can blame investors for this behavior? After all, periods of rising volatility often call for maintaining a higher percentage of cash on the sidelines to meet short-term liquidity needs. The problem is that investors have earned almost zero yield on cash in the post financial crisis era. However, due to the rapid rise in short-term yields on U.S. government debt, we finally see short-term bonds as an attractive alternative to cash.
In last 12 months, the front-end of the yield curve has risen by nearly 1%. As of March 5th, the 1-year U.S. Treasury note yields 2.05%, finally above the core consumer price index (CPI), which stands at 1.8%. A 2.05% yield also puts it just above the Federal Reserve’s inflation target of 2%. As such, short-term bonds not only offer relatively compelling income in the current environment, but also provides a bit of an inflation hedge.
The better news, is that interest rate risk at the front end of the yield curve has also fallen. Three months ago, the bond market only priced in two interest rate hikes (blue line in the chart below) for 2018, one fewer than the Federal Reserve’s projection of three rate hikes (orange line). This mismatch left room for the Central Bank to adversely shock the market. But that risk has now abated following the rise in short-term yields which indicates that three rate hikes are now fully priced in (green line).
Rising yields on short-term bonds has another effect. It helps provide a meaningful cushion against further rises in interest rates. The yield cushion is defined as the percentage point rise in yield that would cause a price decline large enough to wipe out one year’s worth of income. As we stand today, to wipe out a year of income generated by short-term Treasury bonds, we would need to see interest rates jump more than one percent. The good news is that at present this seems to be a low probability event, especially given the Fed’s current preference for gradually normalizing rates.