Managing The Risk

We have all heard the old fable of the race between the “Turtle and the Hare.” The Hare jumps out to a wide lead in the race and has so much confidence in his lead that he lays down for a nap. The Turtle is tenacious and tireless. He continues to move forward, however slowly, sticking to his plan without waiver. Eventually he passes the Hare who is asleep. When the Hare wakes up, startled, he gives it all he’s got to catch the turtle but in the end he is unsuccessful and the Turtle wins the race.

Money management is the same. Sticking to one’s plan, managing risk when necessary, and in general thinking of preservation first and foremost, often results in what investors consider underperformance. The reason is they pit the broker or money manager to the S&P 500 and if they fall short, the money often seeks a higher promised return elsewhere.

Let’s look at two managers each with $100,000.

Manager #1 is a manager of risk. Manager #2 uses a straight out “buy and hold” approach, because no one can time market risk. Here is a good example of what can happen verses the two philosophies.

As you can see, the killer for the buy and hold account was year 5. That year is tantamount to last year. I know the S&P 500 was up 28% or so in the year but if this manager was a small cap manager he could have been down 33%.

Let’s say Mr. Jones is about to retire in year five and he has a $2,000,000 portfolio. In year five he loses 33% or $660,000. Do you think Mr. Jones will be pleased with his broker or manager? Probably not. Even though he knocked the cover off the ball when the market was good, when the market was bad he did equally as bad. If the market had been bad, let’s say, for the first four years where would manager #2 be by year 5? Which is better, a 20% return in a year verses 16% return with 1-2 the risk? It’s the risk part that Mr. Jones never thinks about especially in today’s environment. What do a 15-year-old skateboarder and today’s average investor have in common? No Fear!

Here is another way to look at the same concept.

Each account starts with $200,000 in ten positions.  One account using risk management strategies to limit losses while the other account does not.

Each account shows two of the ten positions as winners, two that are even and the other six as losses.  The account using risk management limits losses in those six positions to 15%.  The other account has two positions down 40% and four down 50%.  The account using risk management falls to $192,000 in value while the other account falls to $154,000.

That means for the account without risk management to get back to even, it must rally almost 30% while the risk management account only needs to rally 4.2%.

Let’s assume that after a terrible year the market has three good years, up 15% each year and both accounts participate on the upside.  (In reality what probably happens is the customer just gives up on equities after the account is down just when bonds turn down and equities turn up).  At the end of year 3, the risk management account is up to $292,008 while account not utilizing risk management is only at $234,215.

Learning how to play defense effectively makes your job on the offensive side much easier.