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Risk Controls

“The financial system cannot absorb unlimited money forever without adverse consequences, but the current environment may last a lot longer than most of us expect — and it will likely end much more abruptly than most of us expect. In the meantime, I recommend participating in the bull market, but with tight controls on portfolio risk.”  Michael Price – On Track Report 7/03/2014

Michael Price said it well this week.  I couldn’t agree more.  This environment has rising risk but enough opportunity to warrant a fully invested portfolio.  Tight risk controls are critical so let’s review ours

What is Portfolio Risk?

In the past, we have been guilty of associating risk with portfolio volatility.  In a way, that’s not totally incorrect as every cycle of portfolio loss begins with rising portfolio volatility.  Portfolio volatility is something we should be tolerant of to a degree, as the markets will factually have up and down weeks, or months within a broader rising trend.  We can’t jerk out of every investment each time it has a small down move right?  No, but regular volatility is different from portfolio risk.  So what do we mean by portfolio risk?  Well for everyone who has any significant portion of your net worth invested in something, it means unrecoverable risk of loss.  Unrecoverable seems so absolute but it’s a term that I think is appropriate in light of the magnitude of the bear markets since the year 2000.  When an investor experiences the full brunt a bear market like any of the last two in which portfolios lost 40 or even 50%, investors have a strong history of simply washing out (selling) and sometimes never return to investing.    For example, investors sold in mass and sold massively in early 2009, at the lows and never came back, until after the markets rose a full 185% over a span of 5 years.  It wasn’t until the end of 2013 that we began to see investors slowly creep back into the stock market based on inflows into equity mutual funds. But remember, portfolio values are still sitting back at their low values with opportunities for returns getting thinner by the day.  You can start to see how a significant loss becomes unrecoverable when the pattern of human behavior leads us to make some very ill timed decisions both on the buy and the sell side.  Logically, we therefore look at that entire event as something we want to avoid.  Specifically, we want to have a system in place that tells us when to remain fully invested and tolerant of volatility but also when to move decisively out to a defensive position when normal volatility becomes “Portfolio Risk”.   Which brings me to that system. 

What Are Some Risk Controls?


These are some high level examples of our risk control systems in place that keep our client accounts out of trouble without giving up on rising market opportunities.



Stops are generally a moving line in the sand at the individual security level that are monitored regularly.  When a stop is broken to the downside in the price of a security, it is sold to cash.  Stops can move up with a price of a security effectively following it higher over time giving us the best chance of owning rising securities for as long as the price is trending up.  When the price trend turns down, the stop is hit and the security is sold.  Voila!


Market Trend Following


This is a part of our daily routine in which we measure the health of the market at large including breadth, volume, new highs and new lows, Market price oscillators, moving averages and momentum.  Together, they paint of a picture of market and how it is trending.  Some markets are very strong in trending directionally as we’ve seen for the last two years.  Other market conditions are literally trend-less, moving neither up nor down with any form of sustainability.  Our indicators help us understand what type of market we are in and subsequently, how much exposure we want to have at any given time.  Today the markets are trending strongly higher but the strength of that trend is getting weaker each month for example.  We know that the odds of a market correction are rising without seeing it actually happen.  How much of a correction is anyone’s guess but it will push us into some form of defensive positioning when it happens.


Security Selection


Of course, we could just buy any S&P 500 index with 100% of client’s money and hope that our system will be robust enough to get us out at the right time.   For a portion of our equity models, we do just that.  It cuts costs and often generates some of the best returns in the portfolio.  But putting it all in an index is just too risky when we know that markets (and associated indices like the S&P 500) have experienced crashes, mini crashes and panics losing 10, 15 even 20% in a single day.  Instead we still work to maintain a mix of securities that are both non-correlated to the markets but also non-correlated to each other.  Examples would be gold or silver, bonds, international positions, low and high-grade corporate bonds, or select sector securities.  In our all stock models, like New Power, High Dividend or Worldwide, we work hard to own stocks that march to different drivers.  Some might benefit from rising inflation while others are benefiting from consumer trends or competitive advantage. Held together, we are really spreading out the risk of a sudden and dramatic loss in our portfolio (aka portfolio risk).   


Using Rentals


Rentals are a term we use for securities that have no cost to trade (sell), no redemption fees and no hold periods of any kind.  Rarely do we use anything else in our strategies but liquidity is critical to the risk manager.  We must be able to sell everything when we want to without constraint.  We are still longer-term investors but we are not putting money into things we cannot get out of if conditions change.


We have other gears in our risk management machine but these are a few examples of key elements in our system.  As the markets marches higher, I expect these systems to begin lighting up, giving us some clues and warnings that the risk of unrecoverable loss is also rising.  None yet.  


All of our clients are with us because they are mature investors.  They know and understand what market risk means and they pay us to run our system daily making changes as needed.  This is what we do and we do it well.


Thank you to everyone for another quarter of service.  We will be sending out the quarter end Change of Seasons report next week at this time.  Best of luck to all of us in the second half of 2014!




Sam Jones