Alpha Vee: Get Risk Under Control

(Alpha Vee) Risk is an inherent part of our life. In the immortal words of President Theodore Roosevelt: “Risk is like fire: If controlled it will help you; if uncontrolled it will rise up and destroy you.” In the world of investments, taking risks is a prerequisite for achieving returns, and controlling the risk is the key for a successful investment.

The first step of controlling the risk is to break it down to individual risk components. We will examine and demonstrate the main components and will briefly describe some of the available possibilities to control them. Using the right system for controlling the risk can enhance the investment returns while minimizing the volatility for the investor.

The individual risk components ebb and flow with market conditions. A risk component can be dominant at some period while dormant at others. Identifying this cycle correctly is sometimes described as “an art”.

We submit that the right tools can be used to turn this art into a skill. Here is a list of some of the main risk components, top down:

• Market Risk - At the top of the risks for the equity investor stands the market risk. As Warren Buffett vividly described it: “Only when the tide goes out do you discover who’s been swimming naked”. The market risk may stem from different reasons, but the result is a sharp decline in the large majority of sectors and equities. Any attempt to pick a winning sector or stock is likely to end with a large loss, and even the fact that the loss is slightly smaller than the market will provide little consolation to the investor.

• Sector Risk - The second risk component pertains to specific sectors. Driven by macro events, such as rapid oil price reduction or a sharp change of government policies, some sectors can yield sharp negative returns while other sectors not only outperform the benchmark but have a positive absolute return. Between May-December 2015 the S&P Energy Total Return index dropped -24% while the S&P Consumer Discretionary and Consumer Staples Total Return indices rose 5% and 6% respectively (30% spread).

• Geography Risk - The third risk component relates to global equity portfolios. Geographic allocation may have a great effect on the overall risk. The geography risk is affected by local markets behavior as well as by currency fluctuations.

• Stock Selection Risk - Trying to deviate from a general index and to select specific stocks carries a risk and consequently a potential return. Stock selection involves defining the selection universe and then picking the “best” stocks based on their fundamental and/or technical factors. The type of factors defines the risk level. Choosing value stocks with high dividend yield is traditionally less risky than growth stocks with high growth rate.

Controlling the Risk

Risk can be ignored; risk can be eliminated; and risk can be controlled. For each of the risk components listed above, we can choose to ignore it (embrace the risk) and possibly achieve higher returns on our investment at the cost of high anxiety and potential loses.

We can also choose to eliminate the risk, sleep better knowing our losses are limited, but accept the minimal to no return which results. The smart approach is to control the risk.

This requires:

• A smart dynamic indicator which assesses the risk for each component

• A variety of actions to be taken according to each indicator level

This is only an excerpt. For illustrations, examples and concrete solutions, just reach out to Alpha Vee.



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