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Risk Control


Guest Bronco
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I'll start a new thread from some conversation on another post.

 

If nothing else, maybe we can stir up some good debate.  If we all agree it gets boring.

 

 

Issues - what is everyone's system for risk control?  Some examples...

 

1) keeping a position to a certain size of portfolio (and if so, what %)

2) informal or formal stops below purchase price (if so, what %)

3) recognition before purchase whether it is a trade or investment

4) recognition of why you own an investment and what needs to change to get out (CEO leaves, bad accounting, better product offering from different company)

5) macro indicators?  micro indicators?  technical indicators?  all of the above?  none?

 

 

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for me here are some things that i do

 

1. i don't short (this is a big one)

2. keeping position to their respective size depending on the opportunity (how confident i am, probability etc etc). Size ranges from less than 1% to 10%. I usually like to start with a very small position and accumulate overtime (there are definitely draw back to this approach but this has work for me so far, i have miss opportunities but that is how it is right now)

3. i do have different investment types, some are long term, some are catalyst driven etc.

4. i try to go through the criterias and see if things change everytime new info comes up

5. i don't use much macro yet or any of technical indicators, i am purely bottoms up guy

 

hy

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hyten - thanks.  My guess is that we have many good investors on this board and the responses will be all unique and different. 

 

 

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100% equity portfolio:

 

1. Annual sector review. Reallocated/new $ to the worst sector

2. Bi-annual macro review. Drives the Equity/FI mix, leverage, options/futures decisions

3. Don’t short physical, & only sell options – we don’t buy them

4. Per holding EMV after every quarterly release, significant announcement. Drives the hedge decision.

5. Maximum per holding $ investment is the initial investment. Maximum 3-5 equities.

6. Take unrealized gains > 30-50% by selling down & changing the cost base. Repurchase to the amount of the unrealized loss & change the cost base. Total $ investment never to exceed the initial investment.     

 

The risk attributable to any given holding decision will automatically decline as either the portfolio grows, or the holding decision is sold down. But a given investment in XYZ may be the aggregate of multiple holding decisions.

 

New $ investment is expected to at least double within 4 yrs. MOS is the long horizon, & always buying quality in an out of favor sector. The more speculative the shorter the horizon; the thesis is either right or it is not – & you will generally know within 2 yrs.

 

Equity margin is offset by FI. We risk adjust the instruments - 100% for a Canada’s/T-Bill’s, 25% for a speculative deb &/or zero coupon. 100K of equity margin is equivalent to 400K Face Value of zero’s. When the portfolio doubles, ½ the gain goes to FI

 

Relatively low maintenance, but you must know your companies.

 

SD

 

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Stop losses are the most misused risk management tool imo. They do not help manage risk - they just give you the illusion and false comfort of risk control.

 

While they do limit your losses on individual stocks, they don't limit losses at the portfolio level. Say you keep 10% stops and you get stopped out because of a market drop. What do you do next? If you don't reenter, you risk missing out on a market recovery. If you reenter the market, you expose yourself to another 10% loss. In a prolonged and trending bear market or a choppy whipsawing market, you will run out of portfolio before you run out of stops.

 

There is also an unintended consequence of using stops. People who use stops often give themselves the excuse of not thoroughly analysing their "investments" because their "risk is limited."

 

[btw, "stop profits (taking profits based on a fixed % profit)" are equally illogical.]

 

The best risk management tool is to be realistic about what you do and do not know and to do only things that you understand. It is not always easy but I don't think there is any other way to go.

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1. I don't short.

2. I don't borrow.

3. There are very few eggs in my basket, so I can know them and watch them better than if I had many more.

4. Anything I buy, I have to be happy holding for 5-10 years even if the stock markets were closed.

5. I'm ready to pay up a bit for quality, which can avoid me bad surprises often found in lower-quality corps.

6. I have emergency funds that would last me a couple years, so if I lost my job I wouldn't be forced to sell stocks at what would potentially be a bad time.

 

That's an extremely simple approach, which is why I think it has a better chance of working than complex methods.

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I'm with Myth on this - I don't short.

 

I do not limit my positions to a certain size of my portfolio.  I put my biggest positions in my best ideas (assuming I have good ideas - don't ask my wife).

 

I will trade around positions I like.

 

I will sell puts put only a small portion of my portfoliio.  I will sell covered calls although not really a fan in general.  I do buy puts when I can if they are cheap (real cheap).

 

I tend to buy companies with what I consider kick ass balance sheets like Rite Aid and MGM.

 

Just kidding - something like Loews and BRK - that is an addtional safety measure for me in addition to getting a good price on the stock.  To me, that is great protection against risk.

 

I do feel I am a bottom up investor but damn you need to look at the macro, as we are in periods of rolling bubbles.  Maybe technology, gold, or oil is the next one - who knows?  But we aren't close yet in either 3 IMO.

 

Keep up good dialogue.

 

 

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A brief note:

Taking unrealized gains & changing the cost base does not mean sell the entire holding:

 

Assume 100,000 shares bought @ $2/share. Total investment of 200K

Price rises to $3/share. Unrealized gain = 100K [100000*(3-2)]

Sell 33,333 shares @ $3/share to raise $100K

Retain 66,667 shares & change the cost base to $3/share. Total investment of 200K

 

You have the same investment in XYZ

Portfolio increased by 100K, so XYZ is now a lower weighting – less risk

If the share price falls, you only lose on 66,667 shares vs 100,000 – less risk

If the share price rises, you profit on your remaining 66,667 shares.

 

SD

 

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A brief note:

Taking unrealized gains & changing the cost base does not mean sell the entire holding:

 

Assume 100,000 shares bought @ $2/share. Total investment of 200K

Price rises to $3/share. Unrealized gain = 100K [100000*(3-2)]

Sell 33,333 shares @ $3/share to raise $100K

Retain 66,667 shares & change the cost base to $3/share. Total investment of 200K

 

You have the same investment in XYZ

Portfolio increased by 100K, so XYZ is now a lower weighting – less risk

If the share price falls, you only lose on 66,667 shares vs 100,000 – less risk

If the share price rises, you profit on your remaining 66,667 shares.

 

SD

 

 

But that's exactly my point. You only reduce the risk on the individual position. At the portfolio level, it is not clear whether you have reduced risk. If you take the $100K and invest in another stock that is more risky than XYZ, you have increased your portfolio risk. To reduce risk in a portfolio, you have to switch from a more risky stock to a less risky one based on your analysis at any one time; switching it based on a mechanical % limit is not the risk reducer it appears to be.

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Agreed. On a per position basis it just makes you take gains & reduces your share count over time. Desirable as you want to see the risk around the decision come down as experience with the position accumulates.

 

Nature of the reinvestment risk also changes. If the cash reduces leverage, or goes into T-Bills, there is direct risk reduction. If it goes into 2 or more new/existing equity positions - not so much.

 

We look upon the risk much as the Spanish did in the 17/18th Centuries.

If your Galleon made it back from the new world you were rich - but you took roughly 1/2 the gain for yourself & reinvested the remainder in risk spreading syndicates which outfitted 4-6 new ships to return to the new world to repeat the process. If only 1/3 of them made it back, you were going to be very wealthy, but you had to reinvest in those new ships. In todays terms that fully loaded Galleon might go for 1-2 Billion.

 

SD

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1) I don't have any strict rules in regards to this. Can't see any situation ever in which i would feel comfortable having mopre than 50% of the portfolio in any one stock. At the moment I have 30% allocated to one single stock.

 

2) None, have never even thought about it and don't see the point.

 

3) Yes, I have done a couple of different arbitrages, 2-3 a year this far and I wouldn't call them investments necessarily. Some of them have been blends, though.

 

4) Yes, although it's hard for me to pinpoint one or two factors that would stand out as more likely in most cases. Since I haven't done many workouts or netnets, the catalysts aren't as clear. "Value as its own catalyst", as some would say. In some of the more arbitrage like situations there have been more clear cut catalysts. For example a position in an investment company, which habitually have made buybacks and stock tenders whenever the stock has been trading at a discount to NAV for some time, and indeed did end up doing so.

 

5) Nothing of the sorts, at least not knowingly

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