In a bull market, protecting one’s downside gets punished, and after being burned enough times, people tend to lighten up on risk management, or abandon it altogether.
This doesn’t happen suddenly, it slowly builds over time. In a bull market the more risk you take, the more you’re rewarded, and the more you’re rewarded, the more you forget about risk.
Since the March 2009 low, there have been 17 pullbacks of 5% or more. During each of these declines, buyers who stepped in were rewarded, sellers on the other hand felt varying degrees of regret.
I saw a tweet recently from Adam Butler that is a perfect analogy for what happened in the stock market over the past few years. He said:
If social distancing is successful it will be viewed by most people as unnecessary in retrospect.
This is the essence of risk management, and why so few manage risk.
I want to talk more about risk management, and in order to frame this discussion, I want to look at one of the simplest ways that equity investors can manage their risk, using the 200-day moving average.
For this exercise, when stocks are above their 200-day moving average on a closing daily basis, the model invests in the S&P 500 (SPY), and when it closes below, it invests in bonds (AGG). It assumes perfect execution, no transactions, and zero taxes.
Please don’t focus on the particulars of this strategy or ways to improve it. I only use it as a way to frame how we think about risk management. You can replace this strategy with anything that isn’t 100% long the stock market and the points should still work.
When evaluating an investment strategy, at some point you’re going to want to see the returns. For some people this is the first thing they look at, for almost all people it’s either the second or third.
So, how did this strategy do? (Again I’m making a broader point about how to think about risk, not the merits of this particular strategy, please do not get caught up in the details). Risk management lagged buy and hold by a significant margin. It would have left an investor with just 70% of the amount of money had they just bought and held. “What a waste of time” potential investors might say to themselves.
But looking at growth of $1 is perhaps the worst investment metric one can look at when evaluating performance. It tells you nothing about an investor’s experience.
As we’ve learned over the last few weeks, long-term returns don’t mean anything if you can’t survive the short term. In order to get a real sense of how one strategy performed versus another, it helps to look at rolling returns, which gives you a moving picture, as opposed to growth of $1, which provides only a snapshot.
You can see in the chart below that using the 200-day outperformed some times and underperformed other times. Looking at it this way gives you a better sense of the range of outcomes- albeit in the context of a bull market- and whether or not you can handle the differences between that and the index.
Digging deeper, we can see each buy and sell decision to determine what sort of turnover there was and how often the strategy sold only to buy back higher. There were 32 round trip transactions, and on 31 out of 32 times, the buy was higher than the sell. Sell low, buy high, rinse, repeat. How long can you do this before you throw this system in the garbage?
The average buy was just 1.9% higher than where the sell occurred, so no harm no foul, really. Frustrating, sure, but if you frame risk management as paying insurance premiums, then you sure as hell don’t hope to ever collect.
If the whole point of risk management is to protect your downside, than the drawdowns matter at least as much as growth of $1. So in that sense, maybe this strategy should be removed from the trash can in which you just deposited it.
One of the most important and least spoken about aspects of risk management is position sizing. In the case of risk management via asset allocation, it’s the size in stocks versus your size bonds. In the case of alternative strategies it’s how much is enough but not too much? If you know that the majority of signals are false positives, and that one right signal can pay for all of the failed ones, then how do you have enough that it’s in place when it works, but not too much that so that you blow out of it before you need it.
In a bear market the more risk you take, the more risk you feel, and the more risk you feel, the more you don’t want to feel it anymore. Which is why balancing the upside and the downside is the real essence of risk management.
Risk is always present even if we don’t always feel it. Manage it accordingly.