Proactive Risk Management

Published on 04/02/19 | Catherine McNey & Saurav Sen | 5,074 Words

The BuyGist:

  • We don’t know when a fear-driven market correction will occur. And we don't how bad it's going to be. 
  • However, if it does happen, what is the magnitude of correction we can expect. We calculate that.
  • If the market falls by that much, how much can we expect our portfolio to lose. We calculate that.
  • This is a short-term risk. Ultimately, the main driver of returns in our portfolio will be the fundamentals of the underlying companies.
  • So, we can either ride it out or we can be a little proactive to soften the blow. 
  • If we decide to soften the blow, we can do a few things: 
    • Reduce our exposure to the holdings that contribute most to the expected portfolio losses. We identified those.
    • Buy a VIX index.
    • Buy a Call Option on the VIX.
    • Buy a Put Option on the broader market.

Fasten your Seatbelts.

At The Buylyst, our definition of risk is simple: Permanent Loss of Capital. When we look ahead – proactively – we break that down into 2 parts: 

  1. Probability of Permanent Loss times
  2. Size of Permanent Loss.

In this worldview, we’ll focus on #2: Size of Permanent Loss. We can come up with all sorts of statistical models to estimate both variables, but we’ll keep things simple. As far as probability is concerned, let’s assume that there’s a pretty good chance of a market correction in the next few months. Market corrections, in our view, don’t usually translate to permanent losses – that is if you don’t sell low (in panic) only to buy high later (because of FOMO). We see market corrections – like the one we saw in the last quarter of 2018 – as turbulent air pockets. We’re perfectly happy to ride them out, because at The Buylyst we have a solid, well-researched marker for how much our holdings are worth. 

Our main quantitative tool for Risk Management is Margin of Safety – not overpaying for an asset. Since we do the heavy lifting – the valuation work – we know what our holdings are worth, which informs our purchase price. Usually we buy assets at prices that are much below what we think they’re worth. The difference is Margin of Safety. The idea is that even if we’re wrong about our (conservative) estimate of intrinsic value, we shouldn’t lose much money. 

Our main qualitative tool for Risk Management is having well-thought-out worldviews. This keeps us away from playing the wrong sports. We like tailwind behind our holdings. We want to be invested in growing sectors, that will make our world a better place and our lives a little easier. We’re invested in Progress. We stay away from undervalued companies in structurally declining industries. In Wall Street lingo, those are called “falling knives”. No thrill in juggling them. 

Having said all that, we don’t like turbulence. Yes, our portfolio has companies that are undervalued in sectors that are poised to grow over the next few years. That’s good. But over the short-term, market corrections are part of the ride, and for those turbulent times we might need to fasten our seatbelts. This article is about seatbelts. 

The basic objective of the seatbelt premise is this: Is there anything we can/should do to smoothen the ride? Can we hedge some of the temporary turbulence without sacrificing overall, long-term returns?

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