February 2, 2015: Risk Management Everywhere

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For regular SAA and TAA portfolios, the next re-balance will be on next Monday, March 9, 2015. You can also find the re-balance calendar for 2014 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Risk Management Everywhere

Risk is an inherent component in our life. When we hear weather forecast says that it will rain, we will bring an umbrella or rain coat, even though it is sunny right now. When New Yorkers were informed that there would be a blizzard in New York city last month, Mayor Bill de Blasio ordered to shut down the city’s subway system. Granted, the blizzard didn’t turn out to be a ‘historic’ one and some complaints were voiced, people implicitly or explicitly understood this was the cost of insurance or risk management.

Super Bowl 2015: ‘Man, What Were They Thinking?’

The Super Bowl on Sunday was a classic example on how risk management was an essential element in sports like NFL football games. Bloomberg had this article that vividly illustrated this concept. The case in point is that, with 26 seconds left and the second down 1 yard to the goal line, Seattle Seahawk’s coach Pete Carroll made a big call to decide to pass the ball instead of running the ball to the touchdown line. Unfortunately, Seahawks quarterback Russell Wilson threw an intercepted pass, derailing the hope for a Seahawk’s game changing touchdown. The rest is history, New England Patriots won the Super Bowl title.

Some may put a blame on Russell Wilson’s bad pass and some may attribute the brilliant interception by Patriots’ rookie Malcolm Butler. But the most glaring mistake here is the risk management one.

The conventional play in this situation is usually to give the ball to your strongest running back to pound through the defense line for the touchdown. In general, it is less probable to fumble or lose the ball in running than passing. In this case, there were two more factors that supported a running play strongly. First, Seahawks has one of the league’s best running back Marshawn Lynch, who had been in a good state up to this point in the game. Lynch is known as Beast Mode as he can move a ball forward even through some of the toughest defense lines. Secondly, this was the second down. If this would fail, there would be the third or the fourth down to try the passing play.

The risk was also a fatal one: if the ball was intercepted, the game would be over, considering only 26 seconds left. The risk and reward in this case is very clear.

However, coach Caroll decided to go for passing instead of running/pushing the ball through because he thought the Patriots were ready for the running game. He thought the passing would be a surprise play. Yes, if this was successful, it would be a more glamorous play.

But he forgot the risk and reward ratio. The conventional trial and (more) true running is safer, though more boring. It should have been the choice.

No wonder even several Patriots players said “Man, What Were They Thinking?”.

This is also similar in investing. When an investor has an over sized exposure in risk assets such as stocks or commodities, it is important to understand the risk of losing 20%, 30% or even 50% in these assets is highly possible and ask yourself whether you can withstand this loss, both financially and psychologically. Try to answer this question slowly by imagining the day to day experience in that long period of time. It is one thing to look at a numerical number or a chart that shows an eventual recovery, it is another to actually experience slow recovery in months, years or even decades while you are still holding the securities.

Another important lesson we learned from this is that one should not out-strategize yourself. Relying on a boring but more sensible way might not be as exciting, but it is safer and ultimately will prove to be a better winning way. As a human, we inherently want to find a better way for everything. We constantly search for another breakthrough. However, in reality, investing is a long term process that has to rely on large sample of data (i.e. long time) to exhibit a strategy’s strength, under the condition that the investments will not be impaired beyond recovery.

Risks in Current Environment

Today’s ISM manufacturing index slid to 53.5, below expectations of 54.5. This is just a data point in the recent stream of disappointing economic data. We like Hussman’s outline of an economic weakening sequence:

Widening credit spreads (i.e. the yield difference between high yield (junk) bonds and Treasury bonds) + plunging commodity prices + Treasury debt yield collapsing + Rising risk aversion ==> (followed by)
Weakness in new orders and production components of purchasing indices ==> (followed by)
Weakness in real sales + real production ==> (followed by)
Weakness in real income ==> (followed by)
Rising new claims of unemployment + later weakness in payroll employment ==> (followed by)
Weakness in economies

At the moment, we are at an earlier stage of such a development. Recent market actions have not been encouraging. Not only markets are experiencing heightened volatility, we are also seeing an increasingly defensive attitude among various stock sectors:

US Sectors Trend

02/02/2015

Description	Symbol	1 Week	4 Weeks	13 Weeks	26 Weeks	52 Weeks	Trend Score
Utilities	XLU	-1.18%	3.56%	6.03%	17.83%	25.11%	10.27%
Healthcare	XLV	-2.31%	2.02%	3.81%	14.61%	28.83%	9.39%
Consumer Staples	XLP	-2.13%	1.21%	4.37%	12.93%	24.97%	8.27%
Consumer Discretionary	XLY	-0.95%	0.51%	3.7%	6.53%	15.45%	5.05%
Industries	XLI	-1.21%	0.34%	1.0%	7.68%	16.06%	4.77%
Technology	XLK	-2.35%	-0.81%	-0.47%	4.17%	20.44%	4.2%
Financial	XLF	-2.13%	-3.43%	-1.8%	5.34%	15.82%	2.76%
Materials	XLB	-0.7%	1.5%	0.12%	-2.33%	11.88%	2.09%
Telecom	IYZ	-1.55%	1.36%	-4.71%	-4.49%	4.6%	-0.96%
Energy	XLE	0.13%	2.12%	-9.51%	-20.11%	-4.92%	-6.46%

In fact, the top 3 sectors are all traditionally defensive sectors.

Furthermore, we are seeing the soaring Treasury bonds, amid weakened risk assets:

We also concur with Hussman on his characterization of the possible market development:

But the assets that will be hit first – and hit hardest in any normalization of yields or risk premiums – are likely to be junk, then equities, then seemingly credit-worthy corporates, with Treasury debt at the tail end of that normalization.

The Cost of Risk Management

So what should we do to respond to the current environment? For Strategic Asset Allocation (SAA) based portfolios, we strongly recommend you to review your current risk exposure so that it is at a level that you can feel comfortable. The cost of managing the risk in this way is that you might lose some upside in the short term if markets start to ascend much higher. On the other hand, the risk of over exposure in risk assets is just too great, given current valuation, economic and market developments.

For Tactical Asset Allocation (TAA) based portfolios, it is a time to reduce risk exposure. However, given the current situation, it does not warrant an all out risk reduction. The cost? When markets start to ascend back higher, the strategy will have to purchase higher performing risk assets at a higher price. But if this is indeed a mega trend, it will not be late to capture the majority upside at a later time. On the other hand, if later on, the trend proves to be short lived, it can result in loss of the portfolio. However, such loss will be recouped back eventually when some big trends are captured by the strategy. The reward: it can reduce loss substantially if the risk materializes and will result in much higher returns in a long period of time because of the loss and win asymmetric relationship we outlined in June 9, 2014: The Arithmetic of Investment Mistakes.

Market Overview

Other than REITs, we are seeing a broad base weakness in risk assets. At the moment, as outlined above, we are cautious and would like to be more risk averse.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now. However, recognizing our deficiency to predict the markets, we will stay on course.

We again copy our position statements (from previous newsletters):

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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