It is not hard to spot signs of the froth and speculation in current markets. Every week seems to throw up cases that challenge any precept of rational investing.
One latest example is dogecoin, a cryptocurrency branded with the image of a Shiba Inu dog, that started as a joke in 2013. At times championed by Elon Musk, dogecoin rallied sharply this week after its supporters encouraged buying of the currency to mark a day celebrating cannabis on Tuesday. Dogecoin slipped later, reducing its overall market value from intra-week peaks above $50bn to $28bn. But it is still up nearly 5,000 per cent since the start of the year.
Elsewhere, another example to emerge has been the stunning rise in Hometown International, the owner of a humble deli in Paulsboro, New Jersey, that recently topped a $100m share market valuation. The deli had $21,772 in sales in 2019 and only $13,976 in 2020 when it was closed due to Covid-19 from March to September. As hedge fund manager David Einhorn remarked in a letter to his investors, “the pastrami must be amazing”.
All this might be entertaining. But as Einhorn also pointed out, small investors who are drawn into “these situations are likely to be harmed eventually”.
It is also indicative of a lottery ticket approach to investing by many retail investors, buying in the hope of others buying. That, of course, is clear-cut evidence of the top of a market cycle. The question for investors with a greater sense of risk management is what to do now.
Understanding and assessing risk is a crucial aspect of successful long-term investing. Academic studies show that investors feel a loss more intensely than a gain. Yet risk management is often underplayed.
That is certainly the case in the world of asset management, where the acknowledgment of risk often ranks below the goal of generating returns that can maintain client flows and fund the future liabilities of pensions and other long-term liabilities.
FactSet this week examined the market rout of March 2020 via a survey of 101 asset managers, insurers and pension plans. The survey identified “a lack of early warning signs within risk analytics as well as a lack of collaboration between risk and those involved in investment decisions”.
This resulted in fewer than half of risk management strategies performing well during the pandemic among the firms surveyed. Nearly half of respondents reported “significant losses”, with 8 per cent experiencing losses of more than a quarter.
This troubling summary coincided with the publication of a new book, Strategic Risk Management, co-authored by Duke University professor Campbell Harvey and Man Group’s Sandy Rattray and Otto Van Hemert. The message of the book is that risk management typically becomes the focus of attention only when portfolios are already in trouble from a market shock.
“The idea for the book is that in a lot of places, risk management is a support function and is not viewed as being part of the investment team,” Rattray, chief investment officer at Man, told the Financial Times. “A portfolio manager should be aware of risk all the time.”
Man’s quantitative approach helped the hedge fund negotiate the market turmoil of last year in a more resilient fashion than some publicly listed asset managers. So what are the lessons for investors?
When market volatility began rising last year, Harvey, Rattray and Van Hermett say that was a signal to reduce equity and credit exposure ahead of a bigger slide in those markets. “The spike in volatility led to sharp reductions in risk assets,” say the authors.
They also suggest tweaks to another aspect of portfolio management known as rebalancing — making sure exposure to certain assets, such as equities and bonds, remain within pre-determined limits. When equities rise sharply in value, they become a larger fixed share within a portfolio and that usually results in sales of the winners and buying cheaper or lagging stocks.
Rebalancing often occurs at set times, such as monthly or quarterly, and also involves portfolios maintaining a relationship between equities, credit and sovereign bonds. That approach should be delayed when markets become stressed, so as to prevent a larger drawdown in the value of portfolios as quality stocks are not automatically sold.
Amid an epic run-up in asset prices and with plenty of central bank cash sloshing through the financial system, no one can predict with certainty the timing of the next market shock. But they can look at the various risk signals identified by the authors and use them to help insulate their portfolios and manage their path through a market shock.
The pay-off from this approach is that a buying opportunity beckons for those that are prepared, while their rivals belatedly implement risk management and slash their holdings.
“The worst time to undertake risk management is during a crisis,” said Rattray. “You are under stress and that makes decisions hard. It is preferable to be in a position of strength to take advantage of fire sales.”