Tuesday, February 22, 2011

Being a Risk Taker

Pinnacle analysts do not get the luxury of taking a personal risk questionnaire to predetermine their attitudes towards risk. To be successful in professionally managing money requires the ability to determine when risk should be put “on” and when risk should be “taken off.” It is the ability to objectively determine when risk is worth taking that separates the best investors from everyone else. Easier said than done! Of course, buy and hold investors believe that risk should never be taken off and stocks should always be held in a portfolio. Alas, secular bear markets are excellent “real world” laboratories for illustrating the folly of permanently putting risk "on.” Nevertheless, it is interesting to consider the difficulties of seamlessly moving from being a risk manager to a risk taker.

For me, the many structural economic problems that remain after “the Great Recession” has made the transition from risk manager to risk taker more difficult than usual. I believe that being a risk taker is the more difficult investment stance to take in most market conditions, regardless of the post-Great Recession environment. At market bottoms when P/Es are low it is easy to believe that they will move even lower. At mid-cycle, corrections always loom. Once new highs are achieved the fear is that the breakout is false and the last buyer will be punished the most. I believe that informed and intelligent analysts are well aware of the bearish case to be made in virtually all market conditions. The negative viewpoint seems informed, intellectual, rational, and realistic. Too often the bullish viewpoint seems to be based on optimism, hardly the most professional method of evaluating markets. In bull markets risk managers prefer to “buy the dips,” since that allows portfolio managers to feel like they are at least doing something to manage risk in a raging bull market. Buying into new highs just feels wrong.

Today’s market conditions exemplify the problems with trying to manage risk in a momentum driven market. Since the market’s severe correction last summer, stock market prices have launched themselves to new highs on a steep trajectory that has been coupled with falling volatility. In short, there have been no dips to buy (the S&P 500 had a 3.7% decline in November of last year). No doubt, the major beneficiaries of this market move have been the risk takers as opposed to the risk managers. History tells us that in market conditions like these, risk managers can catch up to risk takers very quickly as financial markets tend to have very steep and quick corrections from overbought conditions. Even so, being a risk manager has been a thankless job for months now. Pinnacle’s equity benchmark mercilessly punishes risk management in bull markets. At some point we will either have a steep market correction, or transition from a bull market to a bear market. Either will allow us to once again earn a premium over benchmark returns.