Risk Management is vitally important.
No system can identify all kinds of risk, and there is no assumption of certainty in risk management. We recognize that and have adopted 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 and price momentum can get bogged down in adverse stock market conditions. So we are fully invested in the market when condition are favorable as per our indicators while scaling back based on rising market uncertainty at which time our focus grows towards Return Preservation – not losing what we have earned. Scaling back is relatively easier for individual investors over institutional investors, and it’s an advantage an investor should leverage.
Additionally, we use portfolio diversification in our approach to limit company-specific or unsystematic risk. In the case of non-industry specific model portfolios, we have multiple industries and sectors 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 single position limit can be typically in the range of 8%-12.5%.
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 more 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 losses 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, it’s important to shift risk management towards a portfolio approach from an individual stock approach. Our model portfolios have managed such drawdowns historically 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 a position. But in products like the Prudent Biotech Portfolio and the Smallcap Portfolio, where the typical price movement is higher than the broader market, or higher beta, we presently do not adopt stop-loss triggers due to the likelihood of being sold out in the normal volatility or zig-zagging, typical of that industry or market segment.
Also, it is important to note that our systematic investment strategies are developed with the objective of also 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. Furthermore, 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. However, if market conditions warrant, we will issue updates during the month. In addition, sector-focused products like the Prudent Biotech Portfolio cannot benefit from diversification across multiple 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 the volatility is painful. But with discipline and time, quality momentum strategies based on models can avoid the behavioral biases and significantly outperform the broader market.
Our historical performance reflects all these ups-and-downs.