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You are here: Home / Portfolio Management / Risk Management / Ernie Stokely Articulates Portfolio Risk Concerns

Ernie Stokely Articulates Portfolio Risk Concerns

February 9, 2018 By Lowell Herr

Black swans have a way of making one keenly aware that one’s risk tolerance may not be aligned with one’s investment philosophy. For me this emerged as I watched my portfolios melt away the 2018 gains made during the tax bill euphoria.

I had two main thoughts this week. The first had to do with investment strategy. When I rebalance my portfolio on a monthly basis, am I an investor or a trader? Checking the market daily and making buy/sell decisions clearly makes me a trader. Checking the market every 6-12 months to make adjustments makes me (probably) an investor. But, rebalancing every 33 days makes me both an investor and a trader. Being a trader, I must have an exit strategy resonant with my risk tolerance.

The second thought had to do with risk tolerance. Do I know my risk tolerance and if I am comfortable with my understanding of that factor, are my investment/trading techniques aligned with that risk tolerance? The last week in the market makes these seemingly sophomoric questions come into focus. Let’s start with simply checking the portfolio once a month and using some strategy like Kipling momentum to make buy/sell decisions. Lags for the Kipling momentum model used to provide buy/sell decisions for a set of assets are selected to work best with a monthly update process. Note, however, that the portfolio is open and exposed to growing risk over the 33-calendar period 24/7. This delay is also present in the so-called “protective asset allocation” (PAA) crisis detector or similar crisis detectors that use price rate-of-change (ROC) metrics to measure market swings. By the time the monthly update flags market turbulence a portfolio may be experienced significant losses.

Perhaps one is uncomfortable with that inter-checkpoint risk. One can design and build a computer model that checks each day’s closing and compares this to a stop limit or an alert limit based on the trailing high price. I built such a system and thought this to be a 32-day improvement over the 33-day wait period. This would surely suffice to give me warning and protection against a market downturn. It did not. The sudden one day drop (= flash crash) occurred in real time over one day and by the time my system of alerts began to fire my portfolio based on yesterday’s return, I had already lost more than 2%. Hard lesson learned!

Another solutions are to use diversification/decorrelation of assets, invest in more than 3 uncorrelated assets in a given portfolio, and/or use position sizing to control the portfolio risk. When the swan flies in this mitigates the damage. In a flash crash situation we have time to consider whether to sell or stay the course before our losses become too great. The problem with this method is that in between the infrequent flash crashes one is missing out on return caused by the position-sizing process. Does the missed return over a long period of time exceed the flash crash loss without the position sizing? Backtests show the answer to be, “yes,” but does our time horizon for when we need the funds in the portfolio tolerate the added turbulence of flying without some kind of risk-reduction seat belt?

OK, you say, but you used not only position sizing in the portfolio, you also included stop limits. You were saved during the recent flash crash because the stops fired and you cashed out of volatile assets in time. On this last crash you are looking very smart. But, the back-tests that I and others have run show that over the long haul routinely setting stops for downside protection significantly reduces the return. Whipsaws can be a painful price to pay for stop limits.

What to make of all of this? It’s a reminder that temporal issues and risk are tied together, just as risk and return are joined at the hip. Risk grows with time, and downside protection methods that reduce risk will always reduce the longer-term returns. How much risk tolerance does one have? There is no certain answer to this question, and any method that pretends to protect you from the downside without costing you in the long term should be considered with suspicion.

Ernie Stokely

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Filed Under: Risk Management Tagged With: Risk Management

Comments

  1. painshrink says

    February 9, 2018 at 11:44 AM

    Very nice work Ernie. Beautifully articulated. I wish we could have a yearly meeting
    of ITA users to discuss some of the issue you raised-as well as others. Maybe in Oregon-during the summer-(hint hint) to Lowell. Tx Again for all the time and effort you put into this piece. John

    • Ernest Stokely says

      February 9, 2018 at 12:08 PM

      Thanks, John. Great idea! I’m in for an Oregon get-together, especially in July or August when I’ll do anything to get out of the Texas heat. Ernie

      • Lowell Herr says

        February 9, 2018 at 12:10 PM

        Ernie, John et al.,

        There is certainly a lot to see out here. Great hiking, mountains, coast, biking, sailing, etc. As they say, the young come to Portland to retire. (vbg)

        Lowell

  2. Lowell Herr says

    February 9, 2018 at 12:07 PM

    Ernie et al.,

    Thanks, John, for your support of Ernie’s efforts. As I read the blog posted above, I kept coming back to the three-four portfolio approach where one uses different models. This is an admission that I don’t think there is a “Holy Grail” portfolio. If I knew in 1970 what I know now, I likely would have put everything in the S&P 500 with monthly savings and done nothing else. But I did not know all that much about investing in 1970.

    What is my advise at this time? Break the portfolio into three or four different portfolios. 1) set a Buy and Hold portfolio that covers the asset classes laid out in either the Rutherford 10, Swensen Six, or Faber 10. The Buy and Hold or Strategic Asset Allocation Model is excellent for taxable accounts as there is almost no turn over. Portfolios following this model are the Schroding and Weisskopf. 2) The second model is to follow the Dual Momentum model where the portfolio is concentrated into one ETF or index fund at a time. The Galileo, Euclid, Millikan, Maxwell, and Aristotle are portfolios following this model. A variation would be to set up two DM portfolios so a review comes up about every two weeks. 3) The third model is to set up one or two LRPC portfolios.

    For additional diversity, I recommend using different brokers. With TDAmeritrade you end up with one group of ETFs and if Schwab is the second broker, one is exposed to a different group of ETFs.

    If one ended up reviewing one portfolio per week the time for each review is approximately 30 minutes/portfolio. Many weeks it will be less as no changes take place.

    This is one way to control risk.

    Lowell

  3. Ernest Stokely says

    February 9, 2018 at 12:15 PM

    Lowell, I agree. I try to use this method of multiple portfolios with multiple management methods (another form of diversification) first suggested to me by HedgeHunter. It did mitigate the damage of the swan still flying among us. But, I am also cognizant of the price I pay in reduction of return, a price I am very willing to bear. In some of these portfolios I recently reduced equities, but in others I am still invested. We shall see …
    Ernie

    • Lowell Herr says

      February 9, 2018 at 2:18 PM

      Ernie,

      What software are you using to calculate the Internal Rate of Return of your portfolios?

      Lowell

  4. Robert Warasila says

    February 9, 2018 at 2:45 PM

    Ernie,
    So far the risk management sheet worked well with this current correction for me. However your point is well taken, namely how does one decide to reenter. The thought occurs to me that maybe there’s a symmetric choice. Like maybe one could use a buy stop using the SD criterion that set the stop to set a reentry? Or just do it manually. Unfortunately great potential for whipsaw here. So far I’ve decided to wait for next rebalance day to reach a decision. What I noticed however is that although the stop loss set a price to sell, when I run the LRPC it shows most of the stocks that were sold are OK to buy:^ ) Guess that’s just the disconnect quantitatively between the buy/sell criteria and the risk management criteria.
    Just isn’t easy!
    Bob W.

  5. painshrink says

    February 9, 2018 at 3:22 PM

    Gentleman I find all your thoughts invaluable. The preceding exchange, without any concerns for someone’ hidden agenda is what makes ITA Wealth so special. John

  6. Richard Dougherty says

    February 11, 2018 at 12:05 PM

    I believe that everyone who subscribes to ITA Wealth will benefit from a serious reading of Ernie’s very thoughtful post. If you invest you put your assets at risk and there is a cost to all risk mitigation strategies. I believe a prudent investor must understand the risk before they can begin to think about return. Many thanks Ernie. Richard

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