March 9, 2011: Questions

Some great questions showed up in my Facebook inbox; let's take a look...

Why don't you use stop losses to manage your risk?

Let’s say I set up a stop loss on my stock market index and it triggers. Then what? Am I done investing forever? I have to get back in at some point. When? Getting back in would involve making a judgment about what I think the stock market is going to do in the future. This doesn’t make me comfortable because I believe the stock market is very unpredictable. The price of being wrong is too costly. I would rather keep my stock exposure at all times, and find other instruments that have low correlations to the stock market and hold them at all times. I have found this to be a simpler and more effective way of managing equity risk.

What are your thoughts on using options to manage risk? Selling options seems interesting to me.

I am hesitant to buy or sell options because the options market fundamentally does not create wealth. All the options market does is redistribute wealth. It is a zero sum game. Zero sum games can be fun, but statistically there is no expected return.

Also, I would be especially careful about the idea of selling options. I can understand the allure. After all most options contracts expire worthless, right? Many investors see this and think that they can profit off of this by simply selling options. However, this line of thinking fails to take into account magnitudes. If you sell options, most of the time they will expire worthless and you will pocket a small profit. However, when you are wrong the losses are huge. Options can go up thousands of percentage points in a week. The magnitude of when you are wrong is massive. This is commonly seen as an asymmetrical risk profile."

A classic example of an asymmetrical risk profile example is a game of Russian roulette. With one bullet in the chamber, you are going to win five out of six times. Great odds, no? However, when you do lose, the magnitude is so great that the game is no longer rewarding. I see many similarities between Russian roulette and selling options (okay losing money isn’t QUITE as bad as dying).

I highly recommend reading Fooled By Randomness” by Nassim Taleb. He explains asymmetrical risk profiles better than I can.

What do you think a young investor who can handle volatility should do?

Regarding a long-term investment strategy, I would argue that you don’t have to take on extreme volatility to reap great financial rewards. Regardless of age, I don’t think 100% stocks is the efficient portfolio. Diversifying some of your assets into long-term government bonds, t-bills, and gold makes sense to me. My own portfolio is equally split between stocks, bonds, gold, and t-bills. If you want to know why, then read about my journey to this allocation in the articles" section.

 I would question the notion that risk is always rewarded over a long enough time-frame. Sometimes risk is punished, and not only just for a year or two. It is always possible for stocks to have a bad couple of decades and it is prudent to be prepared for any scenario. I think many investors associate the 80s-90s bull market as normal" and that we will inevitably return to that type of growth. It's possible, but not inevitable.

Warren Buffet says you don't need to diversify if you know what you are doing. What do you think?

Warren Buffet is hard-wired to allocated capital. He would be the first one to tell you that if he grew up in a third world country he would be useless. Now, yes its true that you don’t need to diversify if know what you are doing.” But ultimately very few people do, even professionals.

It’s not just understanding how the market works, if you run an undiversified portfolio you need to have information that no one else in the market has. Looking up fundamental ratios, reading articles, listening to conference calls, and doing technical analysis does not constitute a significant edge because everyone else already has access to this data. Much of this information has already been priced into the stock. Warren Buffet is privy to information that very few people have and he possesses a unique mind to process this data. I don't see trying to emulate Warren Buffet working out for most investors.

You talked about how acquiring alpha entails getting a higher return without additional risk. How can one do this?

Well, if I had the answer to this question I wouldn't be in school. I would be running a hedge fund with the name Alpha Hogs, sipping on fine French Bordeaux as investors lined up to throw their money at my fund.

Jokes aside, everyone wants alpha. Even if you don't know what alpha is, you want alpha. Once it is explained to you, you want alpha even more. Alpha is the ultimate holy grail of investing. The sad part is, all the alpha in the world is exactly zilch. It is a zero sum game. One investors positive alpha is another investors negative alpha.

This fact has led me to believe that to pursue it is a waste of my time. I am comfortable accepting the risk reward profile offered by the indices, and diversifying my assets in order to manage risk.

2 comments:

  1. Ryan,
    You have renewed my faith in the younger generation. Only wish I could have discovered the PP at your age. Good luck with your career.
    Sincerely, Roger

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  2. Thanks Roger. I don't post very often but I try to keep it thoughtful when I do. Thanks for reading :)

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