Quantify the downside to realize the upside
The statement below slipped into consciousness
while I was reading texts related to Value at Risk.
"Quality of any life experience is always and only determined by the energy of our beliefs and intentions underlying our actions and reactions. How accurately that energy is processed with energy in the environment is the only cause of all material reality. Any system of symbols such as language or math is designed by man to express and quantify energy for useful application. If we master our own "energy of intention" with precision, probabilities of a positive outcome are dramatically increased. Much of what we focus on really becomes non-essential. This simple realization allows us to use energy with greater awareness and less risk. Money is the scorecard!"
This next statement was found in New Life Magazine -
Medical Profession is a Leading Cause of Death "The Journal of the American Medical Association (Volume 284) states that doctors account for the third leading cause of death in the U.S., only behind heart disease and cancer.
POINT: If the medical profession is the third leading cause of death imagine what the financial service profession is capable of!
With an expected increase of market volatility over the coming decade or so, we have two fundamental choices related to high leverage trading strategies. Totally avoid them out of fear and suffer with unwanted, amplified risk, or learn to strategically apply them for improved results.
Today is October 22, 2010.
A Wall Street Journal headline dated Monday Oct 2, 2000 "Euro's Drop is Hardest for the Smallest - Hedging aids big firms, but for the little guys, rates hit profits hard.” What’s changed? The Journal’s comment can naturally be extended into the marketplace for smaller investor’s financial service professionals and managed futures. To honestly serve our clients (without fear), we need to think about how we think and make the necessary adjustments.
Philip Jorion in Value at Risk (written over eight years ago) has a chapter reiterating the newsworthy losses of financial institutions. Now we have newsworthy demise of institutions. Yet the Chicago Mercantile Exchange Group now clears off exchange swaps to lower risk in our financial system. That is how good the futures industry is and has been! In Jorion’s book, the chapter called Lessons from Recent Losses." He said:
"Derivatives were removed from the portfolios and total use causing increased portfolio risk when the attempt was to reduce it. Furthermore the remaining portfolios may produce non-competitive returns or be subject to higher costs because derivatives offer low transaction costs.
QUESTION: All derivatives were created to reduce price risk of their underlying asset or cash commodity. Does it stand to reason that derivative trading strategies (called investments), a by-product of derivatives can reduce the price risk of their traditional counterparts?
Or can managed futures offset the price risk of managed stocks, bonds, real estate or whatever else exists.
A Simple Strategy for Application
Markowitz proved that the volatility of a total portfolio is less than the sum of its component volatilities. Jorion states that: "An essential component for portfolio comparisons are expected returns - one obviously would want to balance increasing risk against expected return - the great benefit of Value At Risk, however is that it brings attention and transparency to the measure of risk - a component of the decision that is not intuition. "
Shades of Gray Bring Added Comfort
You can build a private label limited risk investment structure, also hypothetically assume that all capital is lost. The process integrates the extreme downside. They call it stress - testing, we call it stress-free living. Now we can say: Within this bottom line maximum possible loss of the entire investment, we have a 95% probability of losing only 15% of that. VAR is a dollar value so the true statement hypothetically needs "On the $500,000 allocation, you have a 95% probability of losing $75,000 over a specified time." The number changes daily as time moves forward because once set up the numbers are built using the daily profit and loss statement. We can also quantify
- exactly how different allocations create possible risk and benefits to the entire portfolio,
- what standards to use for prudent allocation within the investment.
- where the money can come from and finally
- when to increase or decrease the allocation.
The Downside of VAR
Besides traditional limitations the texts speak of, as I was studying VAR, I began to see how inaccurate application can cause unwanted losses. A few examples are:
- VAR may be built using a standard deviation of monthly returns. Fine, but a standard deviation of monthly returns does not accurately reflect how much real capital was at risk relative to that return that the standard deviation was computed with.
- Also comparing strategies is like apples and oranges unless your data is clean.
So, like any statistic VAR application can take you further from truth if applied under these circumstances. As long as you remember where the "potholes" for potential risk are when applying these "man made" tools, you can create a masterpiece of an investment strategy.
The bottom line still remains within you, the application and the people you choose NOT the statistic.
When to Add A New Investment
Now we'll introduce Professor Kevin Dowd. He wrote "Beyond Value at Risk" and other books for Wiley. What I enjoy sharing about his application is that it eliminates any possibility of emotion as cause for bad decisions, which naturally causes unwanted losses. More important it quantifies the bridge of "high standards" we teach you to build.
Kevin begins his book with " An investor should choose a portfolio that maximizes expected return for any given portfolio standard deviation or alternatively minimizes standard deviation for any given expected return. A portfolio meeting these conditions is efficient.
When faced with an investment decision the investor must determine a set of efficient portfolios and rule out the rest." He goes on to explain that any single investment with high volatility is negated when measured on its own merit. It is only useful to consider how that investment contributes to overall risk. An investment may have high a standard deviation appearing to be risky when considered on its own. Yet its return may correlate with the composite in such a way that reduces risk.
"To the extent that the investment contributes to portfolio risk partially depends on the correlation of its return with returns to the other assets in the composite. Indeed if the correlation is sufficiently negative it will offset existing risks & lower TOTAL STANDARD DEVIATION. "
" A new asset will be worth buying if its expected return is sufficiently high relative to the risk it contributes to the whole. The operational discussion rule becomes: We buy the new investment if its expected return is equal to or exceeds a risk-free return plus "a risk premium." The risk premium in turn is equal to a product of factors.
1 - Excess of the expected portfolio return over the risk /free rate of return and a risk factor usually known as the BETA (Bi). BETA which is equal to the covariance between the return on a NEW INVESTMENT and a return to the total portfolio divided by the variance of the portfolio return.
BETA - a relative measure of the sensitivity of an asset's return to changes in the return on the portfolio. Mathematically, the beta coefficient of an asset is the assets covariance with the portfolio divided by the variance of the portfolio.
Covariance - measures the extent of mutual variation between two random variables.
Variance - a squared value of a standard deviation
Kevin goes on to offer formulas and even explains how to apply the rule "backwards" to determine any investment that should be excluded from the total portfolio."
Happiness on Planet Earth
Applying the strategy to managed futures, gave us a method of capital allocation that is holistic in nature. The allocation strategy will also be made available to those who need help. VAR is a statistical measure that can be applied to anything. That also got us excited. We decided that proprietary VAR applications can be used to determine early warning tendencies of original correlations that no longer work, they can be applied to evaluating trade by trade performance, inter-relationships of markets that comprise a portfolio and other sundries of life that NOW need doing rather than writing about.
Investments 4th edition - William Sharpe
Beyond Value At Risk - Kevin Dowd Pg 11
Value at Risk - Jorion Pg 115
New Life Magazine Sept -October - pg 6