A Comparison of Risk Management Tools & Strategies

In my last 2 posts, I have discussed some of the risk management tools and strategies that can be used to manage investment risks. This post puts together all the risk management tools and strategies and discusses their pros and cons.

Tool #1: Value-at-Risk Analysis

Value-at-Risk (VaR) analysis was discussed at length in the post on Stress Testing Your Portfolio. Essentially, this tool serves to estimate the amount of loss at a given probability of occurrence and in a given holding period based on historical price changes. The advantages of this tool are:

• It provides a sense of the loss expected for a decline. By estimating the amount of loss in advance, an investor is better able to prepare himself psychologically for the decline and make rational decisions at the depth of the bear market.
• It allows adjustments in the portfolio to be made. If the estimated loss is too much to bear, an investor can adjust his portfolio to something more palatable.
• It identifies the stocks that are likely to decline the most. Based on this information, an investor can determine if he should still keep those stocks in his portfolio.

However, VaR analysis is not fool-proof. The estimated amount of loss from VaR analysis may or may not be the same as that actually experienced, as the actual decline may have a different probability of occurrence or duration of decline. The disadvantages of this tool are:

• It relies heavily on historical price changes. When the financial conditions are different, the historical price changes may not mirror the actual price changes. For example, the Global Financial Crisis (GFC) was of a different nature from the Dot.Com Bust. Using price changes from the Dot.Com Bust to estimate the VaR losses during the GFC might underestimate the actual losses.
• New stocks have limited price history. Similarly, VaR estimates for new stocks with limited price history might be understated.
• Duration of a market decline is seldom equal to a year. VaR is usually estimated for a month or a year. However, a market decline is seldom one year long. The longer the duration, the higher is the loss.
• Detached from real market events. Although VaR analysis uses historical price changes, it does not reflect a real event, such as the Dot.Com Bust or GFC. The VaR estimates feel like a "statistics" and not potential losses from a real market decline.

Tool #2: Back-Testing Using Actual Market Events

Back-testing using actual market declines corrects for the detachment of VaR analysis from a real market event. It achieves similar objectives as VaR analysis, which is to estimate the potential losses from a market decline. It works even simpler than VaR. To perform this analysis, just take a real market decline, say, the GFC, measure the total decline from the peak to the trough, and apply to the exposure you have to the stock. For example, if you have a $10,000 exposure to a stock, and it declined 40% during the GFC, the estimated loss from this stock is $4,000. Repeat this for all stocks in the portfolio and you will get the estimated loss for the portfolio. As back-testing also relies heavily on historical price changes, it shares many of the pros and cons of VaR analysis. Specific advantages of back-testing are:

• The loss estimate is based on a real market event. It is able to answer the question, "If your portfolio were to go through the GFC again, what kind of losses would it have?". By linking it with a real market event, investors are better able to relate to and prepare themselves for the potential losses.
• It provides a realistic check on the estimated losses from VaR analysis. Unlike VaR analysis, the estimated losses from back-testing is not just a "statistics". It also corrects for the duration that affects VaR estimates.

Specific disadvantages of back-testing vis-a-vis VaR analysis are:

• It does not show the correlation between different stocks in the portfolio. Back-testing only consider the peak-to-trough decline and does not consider the price changes in-between. Hence, the correlation between different stocks cannot be performed for a deeper analysis.

Nevertheless, VaR analysis and back-testing based on actual market events are not mutually exclusive. They can work hand-in-hand to serve as a cross-check on each other.

Strategy #1: Diversification

Everyone should be familiar with this strategy, so I will not discuss too much about it. Just take note that during market crises like the GFC, most types of investment will go down together.

To share my experience during the GFC, I had a fairly diversified portfolio at the start of the GFC. The table below shows the portfolio allocation among different asset classes in Jan 08. Also shown is the % change in value (ignoring dividends) in Oct 08, at the depth of the crisis. (Note: The % change assumed that the portfolio remained constant throughout the period).

	Shares	REITs	Biz Trusts	Preference Shares	SGS Bonds	Cash	Total
% Allocation	18%	7%	11%	18%	12%	33%	100%
% Change	-64%	-66%	-65%	-22%	3%	0%	-27%

As shown in the table, diversification worked to some extent, but not as well as expected prior to the crisis. Both REITs and Business Trusts (BTs) fell as much as shares and served no diversification benefits. Preference shares fell by a less extent, but they were expected to hold steady. Only the Singapore Government Securities (SGS) bonds and cash held steady as expected.


Strategy #2: Never Run Out of Cash

Cash is ammunition. When market prices are severely depressed, having cash on hand allows you to buy on the cheap. Without cash, you will be at the mercy of the market. Psychologically, cash provides a form of security and allows you to be in control. Having said that, buying further might lead to further losses, but at least you have a choice and are not dependent on the market or on others to bail you out.

Although cash is a great friend in times of crisis, holding too much cash might erode their value in times of high inflation like the past 5 years. So, holding them in cash-like instruments such as preference shares and SGS bonds would help to minimise inflation losses. See the post on Behind Every Successful Bear Market Recovery is A Cash-Like Instrument for the experience with preference shares.

Conclusion

The above are some of the risk management tools and strategies that can be useful in managing investment risks. They work to some extent, but they have some shortcomings as well.

See related blog posts:

• Stress Testing Your Portfolio 
• Behind Every Successful Bear Market Recovery is A Cash-Like Instrument
• Different Types of Bears