Risk Management Investing
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As one famous and highly paid economist, who prefers to stay anonymous for obvious reasons, said “forex market prices are likely to fluctuate”. We know it firsthand because we happened to witness these changes. You could have seen it as well. Moreover, we think that these changes are not that bad after all. Definitely, this phenomenon is most beneficial for my business, and we think, for yours too.
However, we are not going to pretend that this philosophical observation will serve as a serious consolation when the mentioned price fluctuations will negatively affect your portfolio, especially, if these changes are significant, sharp, unexpected and right out of the blue. But it often happens that way.
Speaking about future we have to say, if you see any signs that any of your favourite stocks cannot bring the profit you expect, we urge you to always remember that this could be only the tip of the iceberg. Actually, you are to remember this any time, even when your favorite stocks are rising, most probably, you will consider that to be the result of your far-sightedness, but not just pure luck. But the truth is that market risk is the very oxygen we breathe in, it is an ubiquitous, essential and (quite often) unnoticeable element in the world where you manage your portfolio. Our mission, whether we accept it or not, is to control this risk somehow. If we do it well, we are sure to be “rewarded”, as people say; but if not, we are certain to be punished. We always hear the traders we manage say the same thing over and over again: ”Don’t you worry, of course, we are going to control our risks, and we are professionals after all”. Brilliant! Wonderful! Splendid! The only hitch is that managing risks costs money (or have you thought we are doing it for free?). Managing risks is an integral part of managing your portfolio, it pushes this process in the right direction, reminding you about its existence and causing problems at the most inconvenient time. When forex market indicators are promising, and everything is going well, its stern rules nag you in the most boring way. When nothing works the way it should, every step that you should have taken to manage risks, but you neglected it, most probably can be defined as “too little too late”.
Risk management is an expensive and quite often unpleasant (not only for the patient, but we assure you, for the doctor as well) procedure just like those individual medical examinations which my peers belonging to the post war generation have to undergo every year, but if you do it regularly, it may help you prevent the worst consequences. My doctor who is undoubtedly a superb sales manager, advises me to consider these procedures as “investments” (or he didn’t say “investments” but “interventions”? We don’t remember). The fact that this procedure (apart from being a bit humiliating) costs me only a little copayment proves that my insurance company agrees with such a definition. Last year lying on a couch in the doctor’s office and expecting the mandatory annual ritual, we clearly realized the parallel between what we were expecting to happen and the services that we ourselves professionally offer to my clients. Thus, the first chapter title “Investing in risk management” was inspired by my doctor to some extent, and it can be considered as a kind of tribute to him. Managing risks is definitely an investment; the more you see it this way, the richer you will become. As with other types of investments this process demands to allocate scarce resources which you reasonably expect to get some profit. We are biased in this case, but elaborate and effectively implemented investments in the program of controlling risks are sure to bring good and sustainable profits just like any other securities that could get into your portfolio. Here is my good advice for the future: next time when an “invisible hand” of the risk management finds its way into your possessions, just do as we always do – close your eyes and repeat many times: “It is an investment. It is an investment”, and wait until profits start streaming into your wallet.
Risk management Investments will find millions of different ways to penetrate into the process of your portfolio management, which otherwise would have been peaceful and serene. For example, you will have to draw your income graphs, using a certain set of risk factors allowing you to evaluate your future indicators from an absolutely new point of few. If you are professionally engaged in managing investments, this measurement system will probably be developed by other specialists, so from time to time it will bring opposite results to those that intuitively seem to be most obvious. Actually, we will discuss this question a little bit later; the organization that hires you may have its own ideas concerning the best way of measuring and managing risks. They may differ from yours; hence, your actions will be limited in a definite way, in its turn, it may somehow prevent you from being able to effectively manage risk portfolios from your point of view, even if you employ the strictest notions and concepts of this discipline.
There is one more thing: to analyze your portfolio using some risk evaluation mechanisms, IT support, initial data input and other resources are sure to be required, and they have to be paid, as people offering such services usually take money. Either you or whoever you pay for this job will have to understand and analyze the results obtained, at least, in a very general and superficial way. If you happened to do it yourself, the time and resources spent will be inevitably taken away from other important and useful tasks which could have been implemented with help of those resources.
However, if to compare these actions and expenditure with the most important and capital-intensive element of risk management investing, namely, its influence on the decision making process while controlling your portfolio, they are still very insignificant. In particular, considering the risk management your success will be defined by your desire and ability to effectively adjust your portfolio content so that it could serve the purpose of controlling risks and preserving the capital. From time to time it will contradict the actions you might have taken unless you were restricted by the threat of having losses. Of course, these corrections will sometimes cost money, but we are completely confident that it can cost a lot more without making them.
Tools That Can Help You
Almost everyone who will read these lines can completely agree with the main ideas presented here. However, starting from this moment, we are going to focus on something bigger than just moral victories. We mean that once we have established that the idea of risk management as a serious, universal programme correctly implemented in practice is something quite essential, the rest of the time will be dedicated to the joint development of this program that can provide you with the tools to help you:
- Set rational and effective risk parameters:
- Measure your exposure to risks based on these parameters;
- Define potential alternatives and make appropriate corrections and adjustments taking into account the given level of risk exposure and their functionality;
- Precisely define situations when they are needed as well as physiological barriers and market obstacles which may stand in the way of your opportunities and/or desires to insert those corrections, even if they are extremely important for your financial stability.
One of the elements of this process is to develop certain tools allowing you to create a simple quantitative framework and structure to manage risks and measure the indications achieved. This tool set, of course, won’t make us all mighty: for example, it will not predict what can exactly happen to the portfolio at a given time moment, when it undergoes this or that market influence. The following analogy is relevant at the moment: a cardio surgeon opening up someone’s chest can’t predict an absolutely exact sequence of events after he makes a cut. If internal and external conditions are carefully studied in both cases, a certain range of potential outcomes and their probabilities may be seen and evaluated.
Although it is impossible “to design” exactly the result of an individual interference (the portfolio condition or the condition of the chest, we mean) in both of these cases, nevertheless, it can be stated that those who take into account the available empirical information when making decision are more likely to succeed rather than those ones who don’t. Depending on the time and situation most cardio surgeons’ patients survive as well as portfolio conditions improve; it is achieved by applying simple statistical evaluation methods based on the received empirical information.
No one will dare to say that medicine or any other biological sciences are out of the scientific area just because they cannot definitely predict results of some actions or events. However, people often squeak being told that trading and risk management belong to the field of science as well. According to my evaluation both are sciences about life based on different factors, including those ones that enable them to make predictions which lack certainty. Furthermore, if we don’t agree that a lot of information can be taken from certain stereotypes and models tending to their self-reproduction in trading and risk management as well as in medicine and biology, we would say there is nothing for us to do in the market risking our capital. If you don’t support the idea of using available initial data as the basis for the scientific portfolio management, we can’t see any point in spending your time on all this stuff. On the one hand, if you don’t see an opportunity but, in fact, a necessity to create as precise and verified environment for trading as possible, your time will be wasted.
On the other hand, if you really prefer the way of searching for statistical advantages, confidently following the idea of reasonable and dynamic evaluation of both market conditions and your portfolio behavioral patterns, we would say there are some grounds for sound optimism. If during the process of decision making you rely on the appropriate observations, remain meticulous and scrupulous enough to use this information appropriately, your abilities to influence your portfolio condition will provide not only sustainable but also increasing profitability.
Considering that there are the following keys to success:
- Determine a reasonable set of goals for your profitability together with unconditioned liabilities to follow some essential restrictions connected with your investment program.
- Ability to evaluate your portfolio risks mainly based on simple statistical indicators for the previous period.
- Understand how tools at your disposal work to make allowances for these risks.
- Ability to reveal situations when you have to make adjustments due to risks (i.e. when risk profiles don’t match goals and limitations mentioned previously).
- Intention to be consistent in implementing such adjustments regardless of those inevitable temptations pushing you to avoid these actions.
As we will see later, risk management is more about actions than evaluations; there is a subtle difference, unfortunately, it is frequently missed both by those who do it professionally and people whose portfolios are affected by their activities.
Different Forms of Investing
There may be different forms of investing in risks: they are time, resources, perhaps, certain expenses for IT systems, in case your portfolio has a relatively sophisticated structure and to understand the pricing dynamics of financial tools you trade with some definite mathematical models are required. The most important thing is the commitment to the reasonable risk management principle will always make you trade and create your portfolio patterns in the manner that differs a lot from the ones used by people who don’t take risk management into account. In particular, if you start acting the way you are supposed to, you will often feel that you can’t afford to risk such a big share of your portfolio as you may desire when some tempting investment and trading opportunities arise in the forex market. Likewise (although, it is not that often), it may seem reasonable to use rather a big part of your capital in such deals which you don’t appreciate high, but once again they should be realized due to risk management principles.
Thus, the expenses induced due to following reasonable risk management principles turn into the form of direct expenditure and alternative costs. You shouldn’t be surprised that we will encourage you to regard this “sacrifice” not as expenses but as investments, the reasons for doing this are expressed in this chapter title, and they are the principal prerequisite for this entire event.
Many of these concepts were clearly defined before that historical day when we decided to take up risk management. However, implementing them as a whole in the process of managing a portfolio was a slow and painful process if to consider it from my current position. So, through all these years we had to use the simplest statistical principles when managing risks in practice. During this evolution of my efforts we tried, at least formally, to implement a scientific method called OONET9 (those who still remember the school are referred to it). To sum up, we have made the following conclusions:
- There is quite a reliable science underlying all the activities concerning trading, investing and managing a portfolio
- Different components of this science may be pointed out and evaluated from the viewpoint of their influence on financial indicators
- Using a very simple set of statistical and arithmetical tools it is possible to evaluate which elements are effective and which are not in a particular case of portfolio management
- In its turn, quantitative comparisons in different time periods and intervals when success indicators change can be performed. As a result, this comparing can reveal specific elements that cause a negative influence on indicators at difficult times and those that perform well at good times
- Although it is not always possible to cope with these or those challenges without creating some other difficulties in portfolio management, it is really useful to understand all these undercurrents for traders to be able to focus their efforts and opportunities in the right direction and minimize flaws with the most effective methods available
- This methodology is also very useful when figuring out which market conditions are most advantageous for portfolio managers and which ones work against them. Therefore, this knowledge allows adapting the resource allocation to existing market opportunities more effectively
- Once a portfolio manager finds some potential areas to be improved, to cope with problems (and make this process controllable) it is a good idea to apply the same set of simple statistical instruments used at defining problem areas
This site and the risk management strategy that we are going to describe are simply based on these issues. We are going to start our discussion with determining the set of fundamental objectives which can help in measuring your success or failure at the macro level. At this point you will have to think hard about options you have, because there are several basic goals that reasonable investors can put forward, each one of them being based on the definite combination of market and personal facts and implies slightly different approaches to portfolio management – we will prove that later when we get to this stage.
After we determine the appropriate goals to analyze t indicators, the time comes for creating the set of statistical instruments to describe your portfolio from the quantitative point of view. The first element will be what is usually called a time-series analysis of profits and losses, it will be used to scrupulously examine your profitability fluctuation models in time, and mostly it will look like an analysis of graphs showing the exchange rate dynamics of your favorite securities. Consider that to practically understand the time-series analysis you have to learn just a few key statistics concepts, mostly concerning mean value, standard deviation and correlation. In my opinion, all these parameters are practically easy to understand and calculate. Either taken all together or one by one, they allow us to understand absolutely everything: from market behavior types up to relative advantages of trading strategies targeted at using a certain market behavior and gaining capital.
Most probably, you have already seen these concepts somewhere else, perhaps while studying; we consider them to be very useful instruments for everybody who would like to better understand a portfolio management and its components. In this regard we encourage you to check your understanding of these concepts, if necessary. In general, it is very easy to learn them; anyhow, to measure target indicators we will need just a little bit more from that boring area called “Statistics”.
Applying the time-series analysis of profits and losses we will discuss the ways to measure your profitability not only in terms of the money invested, but also as a function of risks that you take upon yourself. Apart from that, we will study the technique of risk exposure according to their levels, it will allow you not only to achieve your goals, but also to guarantee that under most market conditions your losses won’t be higher than the maximal threshold sum which have been previously set in case the economical situation changes.
Correlation analysis will be discussed separately; most attention will be paid to the methods of measuring and interpreting the similarity of your indicators and external factors such as general market conditions as well as internal factors, for example, how actively you trade, how much money you invest, etc.
Having the time-series analysis profits and losses which will help you to determine and evaluate your indicators in a more scientific manner, later on we will describe some optional ways that will help you modify a model, if you consider it affecting negatively on the potential achievement of your goals (or it ineffectively uses deficit resources of portfolio management, for example, risk capital). Additionally, we will tell you how to use the same instruments, which you use to determine the problem areas, to effectively evaluate correcting measures that you will choose. But these methods will be of no help for you while determining which deals you should make, if you operate outside the effective zone. Instead, they will provide you with the means to determine and evaluate the alternatives that you have, which, we suppose, can best suit such an individual process as a portfolio management process. And the last thing from statistics area that we will be touching upon in this site is the characteristics of your indicators not from the time viewpoint but on the level of separate transactions.
The simple accumulation of separate deal data will enable you to do a lot of things: from deducing the correlation between the quantity of your right and wrong decisions in the course of deals up to determining how long you are holding this or that position and how it affect profitability.
Apart from that we will tell you about such things as determining and analyzing the indicators of separate securities, sectors or forex market segments and sides (long and short) as well as the sum of the capital used in separate transactions.