risk management

What the Downfall of LTCM Taught Me About Risk Management

Let me share a cautionary tale about risk management.

I will never forget the story of the hedge fund, Long Term Capital Management. I was a senior in college and very interested in a career on Wall Street. One of my teammates from the hockey team who is a year older than I am had just started working at LTCM that summer. This was an amazing opportunity for him. The firm employed Nobel Prize winners and was run by arguably one of the most successful bond traders on the street. 

After a few years of success, LTCM was the envy of Wall Street. Investors were clamouring to have the fund take their money and college grads with an eye toward The Street sent resumes to LTCM in the hopes of landing a position, any position. But then, the unthinkable happened and the fund began to lose money and, given their leverage, ultimately shut down in spectacular fashion. The story has been well documented so I am not going to rehash it here. If you are interested in the full story, I highly suggest ”When Genius Failed,” by Roger Lowenstein. I have actually read it more than once.

It turns out that this experience actually was a great opportunity for my friend, just not in the way that you (or he) would think. If he was paying close attention, he would have seen that in order to have success and longevity in investing, you have to manage the risk. It always struck me as odd that these titans of Wall Street and Nobel Prize winners did not have a risk management system in place that would prevent them from imploding.

Every Monday, we host a call for our clients where I give my current views on the equity market as well as other asset classes whose price movements have an impact on U.S. equities. Following my overview, we take on a topic which we think is important to the process of selecting and investing in equities. These topics range in scope from volatility, to earnings season rundowns, to the use of our proprietary trading signals.

What then follows is an open question and answer session where clients ask about specific stocks which they are considering (usually for purchase). However, I was recently asked about my process for managing risk and if there is a predetermined price at which I admit that the trade is not working and pull the plug. The short answer is YES!

I am happy to report that what followed was easily one of the most lively sessions that we have had since I began hosting the call in March. Our 60 minute call lasted for over two hours. I walked through how I manage risk both for individual trades (ATR stops) as well as for strategic portfolio construction.

 

Why Risk Management is One of the Biggest Benefits of Having Technical Analysis as Part of the Investment Process

Let’s start with portfolio construction. As the S&P 500 was making new highs in September, I highlighted key levels, which if broken should prompt investors to consider changing their investment strategy. As the market began to roll over, I identified 2,873 as an important level and when it was broken, I began to adopt a view of “being bullish but with caution.” When pressed on what this meant, I pointed out that if investors were going to buy stocks, they should consider names with lower betas. As the market continued to fall, this view became more solidified. When the 200-day moving average was broken and began to turn lower, my conviction in this stance grew stronger.

My rationale for this view was rooted in technical analysis. The breaking of key support levels and the downturn in the 200-day moving average told me that something had changed in the dynamic of the market. While, I wish I had a crystal ball and could say for sure that the market was either going to snap back quickly or plunge further, this magical ball does not exist (at least I have never seen it). Given the change in the market, I wanted to help clients position in the best possible way for them to participate on the upside (should the market move higher) but also have a measure of protection (should the market continue to fall as it has). The stocks with lower betas should, in theory, participate on the upside but not to the same degree and if weakness continued, these stocks would decline less than the market and certainly less than the higher beta names which had driven the rally.

In my daily notes to clients, I was focused on names in the Health Care, Utilities, and Consumer Staples sectors for long ideas. I get it, it’s not as much fun to own AEP rather than AMZN or DAR over DE but as far as I am concerned, the fun comes from beating the market. And yes, this could mean that your stocks go down less than the benchmark. And yes, changing the structure of your portfolio as the dynamics of the market change is a form of risk management.

Another form of risk management is at the individual stock level. I tell our clients that they should know where they will get out of trade that is moving against them before they get in.  This is counterintuitive to everything that we have been taught about success. Star athletes envision great outcomes before they take the field. We are told to be positive, to not think about what can go wrong. But in investing it is extremely important to think about what could go wrong. It is equally, if not more, important to preserve your capital as it is to grow it.

Whenever, I suggest a stock as a bullish idea, I always include a price below the entry point where the trade should be reevaluated. This is the “stop.” This is the price where the market is telling you that you are wrong. This is the price where you can sell the position and reevaluate it with a clear head. It is rooted in technical analysis. You can always get back in if your process tells you that that is the best option at the time.

You are almost always going to be able to find a reason to stay in the trade once you have the position. You are likely going to search for the one datapoint that “proves” that you, not the market, are correct in sticking  with the trade (this speaks to our biases which need their own post) you may even be enticed to add to your position just as the team at LTCM did. From Wikipedia:

One LTCM partner commented that because there was a clear temporary reason to explain the widening of arbitrage spreads, at the time it gave them more conviction that these trades would eventually return to fair value (as they did, but not without widening much further first).

This is why the combination of fundamental and technical analysis is such a powerful tool for investors. Price (ie: Technicals) is a discounting mechanism and is likely to move before the fundamentals change.

We all have different goals and reasons for investing so I am not saying that you should use the exact same methods of risk management that I advocate in my notes to clients. But you should have a method. You should have a strategy that takes you out of a losing trade when it is clear that the odds don’t favor a rebound.

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