Showing posts with label hedging risks. Show all posts
Showing posts with label hedging risks. Show all posts

Thursday 16 January 2020

Reducing Portfolio Risk

The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions.

Portfolio management requires paying attention to the portfolio as a whole, taking into account 
  • diversification, 
  • possible hedging strategies, and 
  • the management of portfolio cash flow. 


In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors. 



1.  Appropriate Diversification 

Even relatively safe investments entail some probability, however small, of downside risk.
  • The deleterious effects of such improbable events can best be mitigated through prudent diversification. 
  • The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice. 


Diversification for its own sake is not sensible. This is the index fund mentality: if you can't beat the market, be the market.

  • Advocates of extreme diversification - which I think of as overdiversification - live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. 
  • My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. 
  • One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or thousandth best idea. 


Diversification is potentially a Trojan horse. 

  • Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what's worse, for judgment. 
  • The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little, is highly risky. 
  • Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction. 
  • Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail. 




2.  Hedging 

Market risk - the risk that the overall stock market could decline - cannot be reduced through diversification but can be limited by hedging. An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings.


A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures. 
  • This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations. 
  • If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole. 


A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options.

A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling  gold futures.

A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets. 



It is not always smart to hedge. 

  • When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. 
  • Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. 
  • When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. 
  • In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits. 


By way of example, from mid-1988 to early 1990 the Japanese stock market rose repeatedly to record high levels. The market's valuation appeared excessive by U.S. valuation criteria, but in Japan the view that the stock market was indirectly controlled by the government and would not necessarily be constrained by underlying fundamentals was widely held.
  • Japanese financial institutions, which had become accustomed to receiving large and growing annual inflows of funds for investment, were so confident that the market would continue to rise that they were willing to sell Japanese stock market puts (options to sell) at very low prices. 
  • To them sale of the puts generated immediate income; since in their view the market was almost certainly headed higher, the puts they sold would expire worthless. 
  • If the market should temporarily dip, they were confident that the shares being put back to them would easily be paid for out of the massive cash inflows they had come to expect. 


Wall Street brokerage firms acted as intermediaries, originating these put options in Japan and selling them in private transactions to U.S. investors.' These inexpensive puts were in theory an attractive, if imprecise, hedge for any stock portfolio.

  • Since the Japanese stock market was considerably overvalued compared with the U.S. market, investors in U.S. equities could hedge the risk of a decline in their domestic holdings through the purchase of Japanese stock market puts. 
  • These puts were much less expensive than puts on the U.S. market, while offering considerably more upside potential if the Japanese market declined to historic valuation levels. 


As it turned out, by mid-1990 the Japanese stock market had plunged 40 percent in value from the levels it had reached only a few months earlier.

  • Holders of Japanese stock market put options, depending on the specific terms of their contracts, earned many times their original investment. 
  • Ironically, these Japanese puts did not prove to be a necessary hedge; the Japanese stock market decline was not accompanied by a material drop in U.S. share prices. 
  • These puts were simply a good investment that might have served as a hedge under other circumstances.

Wednesday 2 December 2015

Risk Management

Risk refers to the likelihood that your assets will decrease in value.

Risk is unique in that it applies to the probability of losses occurring, and the potential value of those losses.

In finance, risk is considered a type of cost.

All decisions you make have some degree of inherent risk.

Inaction too often has the greatest amount of risk, so rather than becoming paralysed by attempting to avoid all risk, look at it as a type of cost that allows you to calculate whether a financial decision will reap greater benefits that the potential losses and to compare the available options.

There are a variety of different ways to:

  • avoid risk,
  • reduce risk, or 
  • even share risk.


Each of the above has a price.

By calculating the cost-value of specific risks, it becomes possible to determine whether any of the tools available for managing risk are financially viable and are themselves an appropriate risk.

Risk management is a critical part of financial success.

You should explore:

  • the different types of financial risk, 
  • the ways in which risk is measured and 
  • how to effectively manage the amount of risk to which you are exposed.



Additional notes

Ways to avoid risk:  diversification and appropriate use of derivatives
Ways to share risk:  insurance

In the end, the best tool you have available to you in limiting the costs associated with risk is simple due diligence.
  • Do your research, make decisions which make sense to you and keep watching so you know when that decision doesn't make sense anymore.
  • If someone's credibility is in question, risk mitigation can come in forms as simple as asking for a nonrefundable down-payment, just as banks will sometimes ask for collateral before issuing loans.
  • Preparing for losses can be as simple as keeping enough funds available in a liquid form so you can pay your bills until you regain your losses.  
  • The duration of your exposure to losses can be shortened by ensuring you always have an exit strategy - before you commit to a decision, develop a way to undo it in a worst-case scenario.

Like most things, you get out of risk management that you put into it, and as the amount of potential risk increases, so should your intolerance for sloppy risk management.


Monday 20 February 2012

Reducing Portfolio Risk

The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions. 

Portfolio management requires 
  • paying attention to the portfolio as a whole, 
  • taking into account diversification, 
  • possible hedging strategies, and 
  • the management of portfolio cash flow. 


In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors.

Hedging: It is not always smart to hedge.

Hedging


Market or systematic risk - the risk that the overall stock market could decline - cannot be reduced through diversification but can be limited by hedging.

An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings.

  • A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures.  This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations.  If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole.
  • A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options.  
  • A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling gold futures.
  • A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets.  


It is not always smart to hedge.
  • When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged.  
  • Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment.  
  • When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky.  
In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.



Wednesday 28 September 2011

5 "New" Rules for Safe Investing

1. Buy and Hold
History has repeatedly proved the market's ability to recover. The markets came back after the bear market of 2000-2002. They came back after the bear market of 1990, and the crash of 1987. The markets even came back after the Great Depression, just as they have after every market downturn in history, regardless of its severity.

Assuming you have a solid portfolio, waiting for recovery can be well worth your time. A down market may even present an excellent opportunity to add holdings to your positions, and accelerate your recovery through dollar-cost averaging Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/buy-and-hold.aspx#ixzz1ZC8MiDKw


2. Know Your Risk Appetite
The aftermath of a recession is a good time to re-evaluate your appetite for risk. Ask yourself this: When the markets crashed, did you buy, hold or sell your stocks and lock in losses? Your behavior says more about your tolerance for risk than any "advice" you received from that risk quiz you took when you enrolled in your 401(k) plan at work.

Once you're over the shock of the market decline, it's time to assess the damage, take at look what you have left, and figure out how long you will need to continue investing to achieve your goals. Is it time to take on more risk to make up for lost ground? Or should you rethink your goals? Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/risk-appetite.aspx#ixzz1ZC8qhVwu

3. Diversify
Diversification is dead … or is it? While markets generally moved in one direction, they didn't all make moves of similar magnitude. So, while a diversified portfolio may not have staved off losses altogether, it could have helped reduce the damage.

Holding a bit of cash, a few certificates of deposit or a fixed annuity along with equities can help take the traditional strategic asset allocation diversification models a step further.
Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/diversify.aspx#ixzz1ZC921poy

4. Know When to Sell
Indefinite growth is not a realistic expectation, yet investors often expect rising stocks to gain forever. Putting a price on the upside and the downside can provide solid guidelines for getting out while the getting is good. Similarly, if a company or an industry appears to be headed for trouble, it may be time to take your gains off of the table. There's no harm in walking away when you are ahead of the game. Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/know-when-to-sell.aspx#ixzz1ZC9IVW7b

5. Use Caution When Using Leverage
As the banks learned, making massive financial bets with money you don't have, buying and selling complex investments that you don't fully understand and making loans to people who can't afford to repay them are bad ideas.

On the other hand, leverage isn't all bad if it's used to maximize returns, while avoiding potentially catastrophic losses. This is where options come into the picture. If used wisely as a hedging strategy and not as speculation, options can provide protection. Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/leverage.aspx#ixzz1ZC9XvuWx

Everything Old Is New Again
In hindsight, not one of these concepts is new. They just make a lot more sense now that they've been put in a real-world context.

In 2009, the global economy fell into recession and international markets fell in lockstep. Diversification couldn't provide adequate downside protection. Once again, the "experts" proclaim that the old rules of investing have failed. "It's different this time," they say. Maybe … but don't bet on it. These tried and true principles of wealth creation have withstood the test of time.
Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/old-is-new.aspx#ixzz1ZC9pYbAD

Investing can (and should) be fun. It can be educational, informative and rewarding. By taking a disciplined approach and using diversification, buy-and-hold and dollar-cost-averaging strategies, you may find investing rewarding - even in the worst of times.

Read more: http://www.investopedia.com/slide-show/5-tips-for-diversifying-your-portfolio/conclusion.aspx#ixzz1ZCCNZVfl

Sunday 22 November 2009

Responding to risks: Hedging risks

Hedging means taking additional risks that offset other risks, so that if the downside impact of one risk occurs, it is (in theory) balanced by the upside impact of the other risk. 

An example would be betting an equal sum on both sides in a sporting fixture - whatever the outcome, you cannot lose.  In investment or business, a 'perfect' hedge (one where the different outcomes are perfectly balanced) is practically impossible. A contractor can partially hedge his material cost prices of his contract with an advance order with the manufacturer for future delivery.

Hedging isn'tjust an approach to business or investment risk.  We engage in many trivial hedging behaviours all the time in our everyday lives - in any situation where we wish to avoid the risk of commitment.  When we hedge in everyday life, we set up alternatives for ourselves that will minimise the negative impact on us if things don't work out.  Consider the planning of a Friday night out.  We might make tentative plans to go out with one group of friends, but remain open to other offers.  After all, a better offer might come along - with a higher probability of positive impact (more enjoyment).  We are 'hedging our bets'.