Wednesday, March 14, 2007

How to truly minimize risk

With the rise of hedge funds and increase in hedged strategies, I have become increasingly interested in hedging my portfolio against various market risks, depending on my macro outlook. Over the past few years, investors have been able to become more diversified than ever, and although most are more diversified than ever before, there are still many points of vulnerably, and common misconceptions about what it truly means to be diversified. Conversely, strategies such as short sales, options, currency trades, and other "risky" investments are still misunderstood, and can be an important part of a hedged portfolio in the right hands. The below should not be construed as investment advice, and merely outlines my own strategy and thinking.

Common Mistakes:
1) No matter what your stock adviser tells you, a portfolio with 50% US bonds and 50% US stocks is not a diversified portfolio. You are greatly exposed to country risk (that something may happen to the US), currency risk (the dollar dropping), commodity price increases, inflation, increases in interest rates, and many other commonly ignored but important risks.
2) Investing in 300 stocks is not diversified--it is silly. I realize most people do not have the time or skills (myself included) to identify a basket of 20-25 stocks, and instead opt for options like mutual funds, etc. that are spread thin. That said, I would like to emphasize the pitfalls of over-diversification. Lets assume that there are 5 investments in which you have extremely strong conviction, and about 295 that you think are good investments, but not nearly as good as your top 5. Lets examine one scenario where we invest in 25 stocks, and one in which we invest in 300 (all equal weight). Lets also assume that our 5 favorite stocks will, on average, advance 30%, while our other stocks will, on average, advance 10%. Your upside returns in each scenario are:
A: (.2*.3)+(.8*.1)=14%
B: (.016*.25)+(.984*.1)=~10%
Because you spread your investment so thin in scenario B, our best ideas are much less influential then they are in a smaller portfolio. On the downside, though arguments still abound on the proper number of investments to acheive suitable diversification, the general consensus appears to be somewhere between 8-25 (assuming you are investing in quality businesses with a good margin of safety). Remember too that many large companies themselves are extremely diversified, with multiple businesses, product lines, operating geographies, etc. Buy purchasing 20 large cap companies, you have likely diversified in what may be the equivalent of 200 business across 20 geographies. The riskier your investments, the more need to diversify.
3) Most investors do not rebalance their portfolio, but instead let their winnings ride or, worse, double down on investments that have been wildly success (think emerging markets). Portfolio re-balancing after extreme up-ward moves is crucial to reaping the benefits of diversification.
4) Most investors do not consider truly diversifying themselves. For example, if you own a home but do not have real estate exposure in your stock portfolio, don't sweat it. If you are like most Americans (well, American's five years ago, who still had equity in their homes), your home is likely to be your largest holding. Similarly, if you are an employee of Microsoft, do not invest all your money in Microsoft stock. If the company gets hit hard, not only will your portfolio go down, but you may also lose your job, and powerful double whammy.

How to diversify beyond stocks and bonds:
1) Get foreign currency exposure. There are several ways to do this, but the easiest are to:
a) invest in large cap stocks, many of which have global operations and conduct a large portion of their business in non-US currencies
b) invest in foreign bonds or foreign stocks. Make sure that these positions are unhedged, as many funds hedge their holdings. This is particularly important, as the majority of diversification benefits are from the currency and not the different country locale.
2) Make investments with a typically inverse correlation to the stock market. These include:
a) Short exposure--Though given a bad rap recently, I always try to maintain about 25% in short positions. Short exposure has several benefits, including:
-it allows you to be more aggresive on your long side. If I am short, I can use the cash proceeds from my short sales (with some discount brokers, including interactive brokers), and invest in long positions. If for example, i am short 25% of my portfolio value, I can go long 125% without tapping margin. If my long positions earn 10% annually, and my short positions merely break even, I will have generated the equivalent of 12.5% returns, vs. 10% returns without the short. If you maintain 100% long exposure, and short 25%, then the short positions can serve to as protection from a market downturn. This of course, all assumes you short the correct kind of stocks, or hedge out specific risks from your long positions. For example, I held a long investment in RCS (a canadian payday lender), but was concerned about the regulatory environment in Canada. RCS appeared very undervalued, but I wanted to protect myself in the event of regulatory issues. I shorted DLLR (another, more expensive Canadian payday lender with strong canada exposure), to hedge out the risk of the regulatory issues. This form of shorting can be effective for hedging out specific risks.
b) Commodities
c) Gold--I always like owning a small portion of hard assets, and though I am not a gold bug myself, I too believe that the US dollar and the fiat currency in general is in for a day of reckoning at some point in the future. If an when that happens, Gold will be one of the few safehaven investments, as it historically has been.


Jeremy said...

Good article. Could you double check the math though. I believe the first portfolio should only have a 14% return (5/25 * .3) + (20/25 * .1) = .14

Swavek said...

Excellent point on foreign currency exposure, especially as the dollar has been volatile. One question: how do you know if a fund hedges currency risk? (E.g. I'm looking at EEM & VWO for emerging markets, but no idea whether they hedge)