When markets turn volatile, what do professional money managers do? In a previous article, I showed how money managers first develop informed opinions by looking at trends, patterns, and relationships. This time, I want to continue my mini crash course in portfolio management with the next two steps in my 10-point process – a look at how the pros determine downside risk.
5. Determining risk
It is our view that protecting capital is very important to achieve long-term portfolio success. Therefore, portfolio risk management is an important component of our overall portfolio management process. In steps 1 through 4, our objective is to establish an opinion on the trends of both the market as well as our various investment holdings. But now the question is: What if these downward trends continue? How long do we hold a position before we would consider trimming it, selling it, or buying more?
With this thought in mind, we strive to quantify what we consider to be the “downside risk” of each of the markers and securities noted in points 1 through 4. This helps to give us an idea as to what we might be “giving back” to the market if current trends continue. This is where the gut-wrenching decision-making process begins.
The markets are going to do whatever they are going to do. My opinion on the market as to what “should happen” is irrelevant. Some portfolio managers will therefore conclude that the best approach is to ride through the highs and lows and to not try to time the market. Our view is a little different. Specifically, if we feel that a trend has changed direction from up to down, we ask ourselves two important questions: 1) How are we going to “feel” if this trend continues downward and we don’t sell or trim the position along the way? 2) How are we going to feel if we trim or sell the position and the security rebounds and moves higher?
These are two really important questions. If our priority is risk management, we tend to lean towards trimming and selling a position as the trend on a particular investment is beginning to change. We believe that if we protect capital first, then returns will come over time. And our experience has validated this opinion. We have no problem taking profit.
Alternatively, if our primary priority is to “beat the market,” then we would naturally wish to remain invested and ride through the highs and lows. Our priority is notto beat the market, but to generate a lower-risk, more predictable return over time for the benefit of our clients, particularly those in retirement and drawing income from their portfolios. This is why “risk management” plays a significant role in our thought process.
6. Measuring downside risk
At this point we have established an opinion on the short-, medium-, and long-term trends of both the market and our various client investments. In point #5 we began the process of measuring downside risk. In general, to measure downside risk we will return to the short-, medium-, and long-term trend charts and look at the relationship between where a security is trading today and where its short-, medium-, and longer-term trend lines are currently calculated to be.
The gap between the price of the security and the trend line helps to determine what the downside risk of a specific security may be. In other words, we feel that using some technical analysis tools can help us determine and quantify downside risk. This will then influence our decision-making process for each investment holding: Do we hold our current position, do we trim, do we add a stop-loss order, or do we buy more?
By doing this analysis on all of our various investment holdings, we can also begin to see a “relative downside risk” for the overall portfolio. If the portfolio is well diversified, we may feel comfortable continuing to hold specific individual investments with higher downside risk, particularly if they represent a smaller weighting in the client portfolio. Alternatively, if we feel the downside risks are high for an increasing number of securities, then we may choose to trim or sell the higher-risk positions, and thus rebalance the investment portfolio by reducing equities and increasing cash.
Courtesy Fundata Canada Inc. © 2016. Doug Nelson, B.Comm., CFP, CLU, CIM, is President of Winnipeg-based Nelson Financial Consultants. This article is not intended as personalized advice.
