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How to Manage the Risk on Your Investment Portfolio



Risk is an interesting animal. You can take her out, buy her flowers and even marry her. They only thing you cannot do is eliminate her. Risk, like Keith Richards' liver, cannot be eliminated.  It can only be transferred and managed. Insurance policies do not eliminate risk. They transfer it to professionals who embrace it, manage it and monetize it.


In 2016, David Rubenstein interviewed the Chief Executive Officer of Goldman Sachs, Lloyd Blankfein. Rubenstein asked Blankfein a question that, at first, seemed dumb. It turned out to be brilliant. He asked: “Lloyd, what is your job?” One would expect the following answer: “Well, Dave, my job is to make strategic decisions about the bank's products, customers, employees, stockholders, and goals”. Instead, he said his job was risk management. That reply blew me away. The job of the CEO of the world's most powerful and influential investment bank was risk management – not risk transfer or elimination, but management. 


Where do You Start?

  A good place to start is to have an intimate knowledge of the companies in which you are invested. The more you know, the lower the risks.


When I ask people about how Google makes its money, the most common response is through search and advertising.  This is the obvious answer but there is a beast within Google that people often ignore - their Android operating system. The company does not disclose how much revenue is derived from Android. In 2016, Bloomberg published an article based on information that was leaked by Oracle - Google subsequently sued Oracle for the leak. It showed that 40 percent of the company's revenue ($31 billion) and 50 percent ($22 billion) of their operating profit in 2015 was derived from Android.  There is little wonder why Google wanted to keep this number under wraps because it shows what a big fat delicious cash cow Android is. It also shows how vulnerable Google is to a protracted trade war between the U.S. and China.


In mid-2019, Trump signed an executive order making it illegal for U.S. companies to do business with Chinese companies. A few weeks later he rescinded the order and celebrated his incredible problem-solving skills. The press focused on the relationship between Apple and its Chinese suppliers like Hon Hai Precision. Tim Cook from Apple said that they would look to move 15 to 30 percent of their production outside of China.


The press also looked closely at the relationships between U.S. companies and the controversial Chinese company Huawei and the work they are doing in 5G. Huawei had become a pariah in the U.S. in that it is often accused in the right-wing press like Fox and Friends for spying on Americans and stealing their technology.


No one mentioned Google. Then Google did something quite unusual. Their top dogs petitioned the White House to rescind the order for the impact that it would have on Huawei. Why in the world is Google (or Alphabet as the holding company is now known) so interested in Huawei?


After Samsung, Huawei is the biggest buyer of Android software. More than 90 percent of all the world’s phones run on Android while the rest are Apple phones using IOS. The Chinese mobile giants (Huawei, Oppo, Vivo, Lenovo, and Xiamoi) all use Android. If Alphabet is not able to sell them Android, that is a massive kick in the groin for Google.


When the executive order was signed, Huawei users faced an uncertain future. Their Android operating system would not be updated and they would no longer be able to download or update American apps on the Google Play Store such as Snapchat, Instagram, Netflix, Uber, and others. I personally could not give a rat's bottom about Snapchat but when I cannot download the newest season of House of Cards or Breaking Bad, and my Uber app doesn’t work, I start looking for heads to clunk together.


Huawei announced that it was seven years down the road in developing its own operating system known as Hong Meng. Huawei also announced that this new OS would not be a cheap imitation of Android. It would be 60 percent quicker and would support all the Android apps. Millennials all over the world with Huawei phones breathed a collective sigh of relief when they realized that they could keep wasting hours adding dog ears and mouse whiskers to their photos. Less relaxed was Google. If Chinese mobile phones migrated to Hong Meng, they would lose billions of dollars in revenue.


Understanding the business and its revenue breakdown makes you a better risk manager.  The secret of successful portfolio management is not buying a thousand stocks through a mutual fund or an ETF. It is buying a handful of stocks in which you have a deep and intimate understanding. Buffett likes to invest in a business that is simple to understand. In a simple business, it is easier to understand the expected return and the potential risk.


Value at Risk


The most commonly used risk tool in portfolios is Value at Risk - also affectionately known as VaR. There is a heated debate between the father of VaR Phillipe Jorion and Nassim Taleb. Taleb is a Lebanese-American essayist, scholar, statistician, and former trader and risk analyst. He authored "Black Swan" and was one of the few people who saw the 2007/2008 financial meltdown before it happened. 


Taleb is a vocal critic saying that VaR is not unlike an airbag in a car. It works very well until such time as you are involved in a crash and at which point it is completely useless.  I find myself more in the Taleb airbag camp. VaR does have a role to play, although not nearly as important a role as Jorion would think. VaR is the Kevin Costner of finance – in a movie of 120 minutes, he should be given no more than 15 minutes of air time.


If this is the case, why is it so widely used? The answer lies in the size and influence of the pension market globally and specifically in the United States. As at the end of 2016, according to information from the Federal Reserve, total assets under management in the pension market were $19.1 trillion which made it larger than the U.S. GDP.


Half the assets under management are in public pensions and the other half in private pensions.  We are going to focus on the former. These funds manage the retirement savings of teachers, policemen, firefighters, animal control officers, correctional officers, bailiffs, transit authorities, crossing guards, coast guards, soldiers, immigration and customs inspectors, etc.  They are administered by a board of trustees.


There are different kinds of trustees. Some are professionals from the world of finance and portfolio management. Others are member-nominated trustees or member-nominated directors.  They are nominated by the civil servants to ensure that their financial interests are protected. VaR is widely used because it is simple to understand by nonprofessionals such as member nominated trustees.


The Essence of VaR


Any person with three fingers can understand VaR because it explains risk in three numbers. Number one is the amount of money you can lose. Number two is the confidence interval and number three is the time frame over which this money could be lost.


To illustrate VaR, we are going to use the most globally diversified equity ETF on the face of the earth . The iShares MSCI ACWI ETF is an exchange-traded fund incorporated in the U.S.A. The ETF tracks the performance of the MSCI All Country World Index and holds over 1200 equities in developed and emerging markets. With this ETF you own 80 percent of the world's market capitalization and in 2019 had almost $11 billion in assets under management . This confirmed that the world is not short of diversification disciples. As of the end of October 2019, the 95% 1-year VAR on this ETF was 17.55 percent.


This meant that given a 95 percent confidence interval, the ETF could lose 17.55 percent or more in one year. At this point, the policeman takes out his Taser, plants it firmly on the table and says "what the %$#@ is a confidence interval"?


No problem, VaR has you covered because it is very simple to convert a confidence interval (a term that very few people understand) into a probability (a concept that everyone understands). You simply take 100 and subtract the confidence interval (95) and you arrive at the 5 percent probability. This means that we are now ready to rephrase the risk of the fund to Lieutenant O Reilly who is now polishing his Taser: "there is a 5 percent probability that the fund could lose 17.55 percent or more in one year". Disaster has been averted, and the mild-mannered primary school teacher can put her bottle of mace back into her carpetbag.


How are expected losses calculated?  Do we make use of a crystal ball, do we use weather forecasters or perhaps an expert in the reading of tea leaves or tarot cards? It would be really cool if that was the case but alas no. Three different forecasting models are used. I will present to you the three models in the most subjective way possible and I will then leave it up to you to decide which is prettiest, or the least ugly.


We will go directly to the swimsuit edition of the beauty pageant where all is laid bare and imperfections are more difficult to hide.


Contestant 1: Miss Parametric VaR


Wearing the luminous lime retro styled bikini with the push-up top, Miss Parametric VaR's genealogy is the bluest of blue-chip. She is a direct descendant from Merton Black and Myron Scholes – albeit genetically modified due to the yin/yang imbalance in this relationship.  All the flaws of the Black and Scholes option pricing model can be evidenced in Miss Parametric VaR. She suffers from the assumption that market returns are normally distributed and crashes do not happen.  Miss Parametric is a cockeyed optimist. She believes that finance is underpinned by ethics, moral character, intelligence, empathy, and compassion. She is a country bumpkin and knows how to drive a tractor.


Contestant 2: Miss Historical VaR


A keen student of economic and renaissance history, wearing the caveman styled leopard print and weighing in at under 50 kilograms, Miss Historical VaR is a gal that is deeply rooted in the past with almost no prospect of developing and independent view of the future. After the dot.com crash in 2000 regulators went to great pains to ensure the following health warning was included in the marketing material of all financial products: past performance is no indication of future returns. Miss Historical VaR believes that this is ungodly and hankers for the days of chivalry, chaperones, and horse-drawn carriages.


Contestant 3: Miss Monte Carlo VaR


From the glamorous streets of Monte Carlo, where the city never sleeps, where the official color is gold and the international passport is pleasure, welcome Miss Monte Carlo in the diamond sequined one-piece bathing suit. Everyone wants to know her name. She has read "War and Peace", speaks seven languages and has a passion for working with less privileged children in northern Africa when she is not working towards world peace and finding new ways to split the atom.


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