Risk Management is critically important.
Nonetheless, no system can identify all kinds of risk with complete certainty. We recognize that, and have built a layered risk management approach to improve our risk management function.
Our various Risk Management layers include a series of market indicators that determine our entry or exit in the broader market. Even stocks with good earnings momentum get bogged down in adverse broader stock market conditions. So we are fully invested in the market when our indicators recommend, while scaling back based on rising market uncertainty, when our focus becomes Return Preservation – not losing what we have earned. Scaling back is relatively easier for individual investors over institutional investors, and it’s an advantage investors should leverage.
Additionally, we use portfolio diversification in our approach to limit company-specific or unsystematic risk, as well as in the case of non-sector products we have multiple sectors and industries represented in the portfolio.
Thereafter, we limit the amount we invest in any single stock. Depending on the investment product you subscribe to, such a position limit can be typically in the range of 8%-12.5% range.
As a final risk management defense, we close out a position at the end of the month if it loses its ranking as determined by the models. Sometimes these positions can be running a material loss at the time we close them out. We don’t dwell on it and simply replace the stock with one that the quantitative models determine to be promising.
Even all of the above doesn’t guarantee that there will be no blow-ups. That is unavoidable in any stock portfolio. We have had such instances in the past and they will occur again. Recognizing that we cannot avoid loses in some individual stocks, we pursue a methodology of managing the losses, when such situations occur, and focusing on the total portfolio return. As an investor, one must shift risk management towards a portfolio approach from an individual stock approach. Our model portfolios have managed such drawdowns, and still outperformed the market indexes significantly. The objective of our Risk Management approach is to diminish the probability of losses and blow-ups, while equipping our portfolio to manage the losses when they do occur.
In some products, we may consider using stop-loss triggers to liquidate our positions. But in products like the Prudent Biotech Portfolio and the Smallcap Portfolio, where the typical price variance is higher than the broader market, we presently do not adopt stop-loss triggers due to the likelihood of false positives or being sold out in the normal volatility of the sector.
Also, it is important to note that our systematic investment strategies are developed with the objective of maximizing returns. Consequently, the model portfolios will be much more volatile than the broader market as represented by the S&P 500 and other indexes. Also, we only reset the model portfolio at the beginning of each month, and consequently there can be times when the market conditions change faster than our response. In addition, sector-focused products like the Prudent Biotech Portfolio cannot benefit from diversification across industries, and consequently will be more volatile.
Finally, please note that momentum investing strategies are very volatile and not for everyone. One has to understand that there will be sharp changes and it can be painful. But with discipline and time, quality momentum strategies based on models can avoid the behavioral biases and significantly outperform the broader market.
Our performance captures these ups-and-downs.