The Dynamics of Risk Management

In managing money and managing the risk of your portfolio, it is crucial that you establish the period and the timing of reviewing your portfolio and strategies. Professionals are likely to review their strategies every day - every minute - as the data come through the screens. An avid investor may review his strategies every day or every week. Others would prefer every month. What is important is that strategy and the assessment of risk is reviewed with periodicity. The closer that you keep an eye on the performance of your portfolio, the more successful you will be. If you do not have the time to perform this task, the odds are that you have too many investments, too many stocks, too many bonds, and too many other assets that you have to follow. The important thing is to choose a few assets, a few stocks, and follow them very closely. If you do not have the time, give your money to a professional portfolio manager, or an administrator who provides you with a weekly summary of the value of your investments. It is very difficult to be successful without a close monitoring of the performance of your portfolio.

The choice of the investment period is very important to be successful in investing. Some investors like to day-trade. They feel comfortable investing early in the morning and after a few hours or a few seconds, selling their positions. The reason they feel comfortable is because they have developed patterns in stock prices; they have developed their own indicators and methodology to invest. They review their decisions every minute after they have invested their money. Every minute they decide if they should continue to hold their current position or if they should sell. The investment period for them is very short. It fits their personality and above all fits with the model they have of how and why stock prices change. They feel comfortable with that model and are willing to make important investment decisions using such models.

There are other investors who have found that there are cycles in the stock market whereby stocks rise for anywhere from one to two weeks when certain conditions arise. For instance, when the market is oversold, volume increases, breadth expands with a larger number of stocks rising, these investors take advantage of these patterns. They have determined that the odds of investing over a week or 10-day period are very profitable for them. Different from the day trader, they review their investment position every few hours, or every day, to make sure the trend is still in their favor. Their personality is not as active as that of the day trader, but it is still a very intense way of investing.

There are other investors who feel more comfortable with longer investment periods and recognize that a favorable trend lasts for several months. This book will provide you with the information to help you recognize these trends. In this case, information should be reviewed every week to make sure the trends and the factors that have helped the investor make the decision to buy or sell are still in place. Other investors have a trading rule of buying only between the end of October and the end of April. They believe in the strong seasonality that exists in the stock market. According to this model, the period of May-October is very unfavorable. Each investor has his own personality and his own psychological requirement when investing. It also depends greatly on the kind of rules the investor wants to follow to make a particular decision. Whatever your personality and emotional characteristics, it is important to (a) decide what your investment period is, (b) recognize that the success of your investment program strongly relies on reviewing the performance of your portfolio, (c) review what caused your decisions to buy or sell, and (d) maintain the flexibility to change that decision if it proves to be the incorrect one. Furthermore, it is important to move in small steps to avoid painful mistakes where a change in investment posture is required.

How do you manage risk? What is the process? Step one is to collect the information. In the following pages, you will find the most important data one should follow to access the risk of the various markets. This book will also provide ways of organizing it so that it becomes easily understood and can be easily interpreted. Depending on the investment approach you choose, you have to select different types of information. The day trader might be interested in sophisticated, technical patterns in stock prices and resistance and support levels, in volume patterns, and in hourly cycles in stock prices to trade. On the other hand, if your investment period is over several months, you have to rely more on economic and financial data and the review of this information should be done every week or two weeks.

The second step in the dynamics of risk management is to develop knowledge - that is, to have a model in your mind to process the information that you have collected in step one. The main objective of the following pages is to provide you with this model - how to process, how to interpret, how to analyze the information collected in step one.

For instance, you will learn the reasons why a strong economy is followed by rising interest rates, and how to relate rising interest rates to the stock market and overall liquidity in the economic system. You will learn to recognize that if liquidity increases and short-term interest rates decline, this usually happens when the economy is fairly weak and creates an environment favorable to rising stock prices. There are many economic and financial factors that need to be tied together.

The purpose of this book is to propose to you a way of connecting all this information and therefore recognize what is happening. This element by itself will help you make important projections in understanding the risk involved in the financial markets.

Step three is the most important phase of assessing risk. In this step one has to evaluate on the basis of the model and on the basis of the information collected, what the risks are for the various markets. The outcome of this step is very simple. Should I increase my investments in a certain asset, should I start selling because risk is becoming too high and it's not worth it to have so much money on the line, or should I just stay with my current position and do nothing? These three conclusions have to be reached at the end of step three.

Let's assume that the investment environment is such that the economy is very strong and because of the previous step we have determined that the economy will remain strong. Let's also assume that interest rates have been rising for more than two months. We will see that your outlook for interest rates, according to the methodology presented in this book, will be that they will continue to rise. This forecast tells you that the risk for the stock market is certainly going to increase.

As risk increases, which also means that the odds of making money is decreasing, the appropriate strategy is to reduce the amount of money that you have in the stock market. You will also have to examine the other options that are available to you. For instance, a strong economy may cause commodities to rise including gold, silver, palladium and platinum. One way to invest under this environment would be to reduce your exposure to stocks, and increase your exposure to commodity-type stocks.

Step four will be the outcome of step three. In step three, let's say that the answer is "yes", the risk of the market is very high and the probability the market will rise from the current levels has decreased greatly. Given the returns one can get from money market mutual funds, it doesn't pay to have all the money in the stock market. The outcome of step four is to decide that based on risk having increased, the money invested should be reduced - the odds of winning are decreasing, so you have to decrease the amount that you bet. Remember what the poker player does when not handed a good set of cards.

The most difficult decision investors have to make is to decide if it is better to be in cash than in the stock market. It is a difficult decision because these are the times when they will always read stories of some stocks rising and making new highs, even if a bear market is under way. What are the odds an investor has in finding those stocks? Very small. When the majority of stocks decline, the odds are that the investor will lose money by owning stocks. This is a good time to fold and to wait for the time when the odds of making money are considerably better. Finally, once you have established the strategy, the outcome at the end of step four, you have to implement the strategy. Based on the period of time you have determined best for you, you will re-evaluate your strategy.

Professional investors re-evaluate their strategy daily because everyday there is some information available that might change their strategy. One has to go back to collect the information that has been published and made available in the last day, process it through the model, decide if risk has increased or decreased, and then develop the new strategy whether one should start buying or start selling or should do nothing. And so this process is repeated continuously everyday. This is the only way to protect yourself against losses and to protect yourself against loosing money.

This is the only way you can make sure that the amount of money you have invested reflects the odds of making money. Again, if the odds of making money are low, you should not invest a lot of money. It just doesn’t make sense.

The important steps to manage risk can then be summarized as follows:

1) Collect information after you have decided what is the investment period that is best suited to your personality.

2) Develop the knowledge and understand the meaning of the information you have collected.

3) Evaluate the risk of the market based on the interpretation of the information you have collected.

4) Determine the level of risk. Is risk high and increasing or low and decreasing?

5) Establish a strategy. If risk is increasing, the strategy is to reduce your exposure to stocks. If on the other hand, risk is decreasing, you may want to consider investing more of your capital in stocks.

These steps should be repeated depending on the investment period you have selected. The day trader evaluates this information and goes through these steps every minute. A 10-15 day investor reviews this information every day. The investor whose investment period is several months, will review this information every week and, at the very least, once a month. (From my book Profiting in Bull or Bear Markets)