Sadly parts or all of this blog might seem repetitive when considered next to other things I have written in blogs or on the Website over the many months that WheelieDealer has been going. However, my thinking is that this is such an important subject that it won’t hurt one bit to reiterate the themes and by giving the subject its own dedicated blog, perhaps it will really get the focus and attention that I would say is appropriate and justified.
I know I have written this before, but for me there are 2 kinds of Risk - Upside Risk and Downside Risk. As predominantly a Long-focused Investor (by ‘Long’ I mean that I want Shares to go up as opposed to when I am ‘Short’ and I want things to go down), Upside Risk is of course a type of Risk that I want exposure to; whereas Downside Risk is something I really want to preferably avoid entirely, or at least to minimise (in reality, avoiding Downside Risk is probably not possible - we can only reduce its impact).
For the purposes of this blog, I then break Downside Risk into 2 major types - Stock Specific and Market Specific.
Stock Specific Downside Risk
This is Downside Risk that is entirely related to an individual Stock - of course such a Stock can have its own Upside Risk as well. I guess this Downside Risk can then be split into 2 main types - that which is a consequence of News specific to the Stock (or even general Market News in the sense that it might impact the particular Sector that the Stock operates within); and that which is more of a technical Market movements kind of Downside Risk - volatility is clearly a component of this.
Hopefully the distinction between these 2 types is clear enough - the News driven type probably has a clearer ‘Cause and Effect’ and quite often it will be as obvious as a Profit Warning comes out in an RNS Statement and the Share tanks. With the Downside Risk that is associated with Technical Movements, it is more about the ‘waves’ of Buyers and Sellers having the upper hand and the usual momentum and volatility effects we see on a day to day basis. Just in a similar way to how Negative News can cause a Share’s Price to fall, a combination of Technical Moves can cause much the same thing - how often have you seen a Stock in a Major Downtrend that just keeps falling even though there is no bad news and the Company is eventually forced to put out a good Trading Update and lo and behold the Share Price shoots up? Simply put, people often Sell because other people appear to be selling - although this obviously forgets that at a given price, there is always a Seller for a Buyer and vice versa - see my Blog below to understand this better:
Anyway, irrespective of how the Stock Specific Downside Risk comes about, we frankly don’t want it !! However, of course it is impossible to avoid it - some People (my current argument is that such People are actually ‘Traders’ they are not ‘Investors’ - see this definition kindly dug out by @A1Mhigh (thanks mate !!)
use Stoplosses to combat this Downside Risk but regular Readers will probably know of my aversion to Stoplosses and in my view you are not really combating Downside Risk by using Stoplosses - you are merely capturing and setting in stone part of that Downside Risk and then moving your remaining Money onto another Stock that then comes with its own Downside Risk which may kick you again - and you miss out on Upside Risk that the original Stock had.
Being an Investor, my thinking is that the best way to embrace Downside Risk is to have a very well diversified Portfolio with a significant number of Stocks and sufficient variety in terms of things like Market Cap, Investment Strategy Type (Value, Growth, Takeover, Income, Defensive etc.), Sector, Geography perhaps, different Stock Betas (this is a measure of a Stock’s Volatility in relation to the overall Market) etc. In addition to this, using the tool of ‘Averaging Down’ in carefully controlled circumstances can help after a specific Stock has suffered from a bad dose of Downside Risk. Please see the following Blogs for more details around these concepts:
How many Stocks should we hold?
Investor or Trader?
Obviously, the theory (and the practice I find, and you know I am very keen to make sure all the stuff I write about or talk about on Podcasts etc. is ‘Real World’ stuff and actually works - not the theoretical nonsense I see so often from the Financial Press) is that by holding a good number of Stocks, any problems that are Specific to one Stock are counter balanced by Upside Risk pushing other Stocks up - so the impact of any one Stock is minimised and over time the Good Upside Risk dominates over the Bad Downside Risk. This is the essence of Portfolio Diversification and why it is one of Investing’s few ‘Free Lunches’.
In addition, ‘Trader Tricks’ like ‘Adding to Winners’ and ‘Starving or Cutting’ Losers can help to reduce the impact of Stock Specific Downside Risk. And of course, going back to first principles, careful Stock Selection and buying Quality will help to reduce Stock Specific Downside Risk. To this you can add ‘Top-slicing’ which means that if an individual Stock grows too big within your Portfolio, you chop a chunk off the Top to lock-in some hard earned Profits and to reduce the impact on your Portfolio if the Stock suddenly gets hit by Bad News.
I fell foul of this twice earlier this year. I had done extremely well on both Tristel TSTL and Sprue Aegis SPRP in 2015 and they had grown to be 2 of my largest Positions. I am a big fan of both these Stocks and I came to the view that there was more Upside on both of them, so I let my Big Positions run. Unfortunately, this turned out to not be so good because both came out with Profit Warnings and the Stocks got utterly spanked - I think at one time SPRP was down 52% on the Day which was shocking and because it was such a huge Position it really hit my Portfolio hard. The lesson here is that when a Position has done well and grown to be way over the usual Portfolio Size for a Stock of its kind (I tend to judge by what Index they are in - FTSE100 Stocks can be larger than AIM Stocks etc.), I must take action and chop a bit off the Top. Another way or looking at Topslicing is to consider it as ‘Rebalancing’ the Portfolio.
Market Specific Downside Risk
I think this is something that many Investors ignore or overlook - I suspect it is because they think it does not affect their Portfolios and/or because they are not experienced at negotiating it or being able to deal with it.
Unless you have a tiny Portfolio of perhaps a handful of AIM Stocks, then your Portfolio WILL be impacted by a General Fall in the Markets. To a large extent it depends on the Market Cap of the Stocks you hold - I haven’t got the exact figures to hand, but the Correlations of Specific Stocks to the FTSE100 are something like this:
- FTSE100 Stocks are 85% Correlated to the FTSE100 Index.
- FTSE250 Stocks are 65% Correlated to the FTSE100 Index.
- FTSE Small Caps are 45% Correlated.
- AIM Stocks are 40% Correlated.
In other words, ALL Stocks, irrespective of Size are Correlated to the FTSE100 Index - the only distinction is that as you go down the Market Cap scale, the Correlations reduce - but there is still a Correlation. The reality is that Stocks are Stocks and they tend to rise and fall together. If you want Assets that are not correlated, then you need to hold things like Cash, Bonds, Gold - but sometimes even these can become Correlated to Stocks (did I say this was easy?!!!)
For evidence of this, you just need to think back to Friday 24th June 2016 after the Brexit Vote shock and on the Monday - pretty much everything fell apart from a few Megacaps with Defensive Qualities like the Big Pharma (AZN, GSK), Tobacco etc. Also companies with Dollar Earnings did well as Sterling got hit so much - but this was unusual - in most General Market Sell-offs, pretty much all Stocks get hit.
In terms of how to deal with it, as with Stock Specific Downside Risk, having a Diversified Portfolio with plenty of Stocks in it will reduce the impact of Market Downside Risk, but it will not eliminate it. The only way I have found over the years to actually eliminate a lot of Market Downside Risk is by use of Hedging - where you Sell something like the FTSE100 Index to offset the Losses your Portfolio will suffer during a Market Drop. However, in reality it is almost impossible to eliminate all the Market Downside Risk your Portfolio will suffer and it might even be undesirable to do so (I have found this out to my cost recently by having an oversized FTSE100 Short Position which is hurting me as the Markets have risen) - I find it is better to do your Shorts erring on the under-sized side of things, when compared to the size of your Long Exposure in your Portfolio of Stocks. Please see my Blog on Hedging here:
As per what I have written in my Blog on Hedging, one way to reduce Market Downside Risk is to sell Stocks or Topslice them before the Markets fall - this is a pretty valid approach I find but my current thinking is that I prefer to use Hedging and not sell much at all - this way I stay Fully Invested in Stocks and I can benefit from Upside Momentum Effects on specific Stocks and of course I can still get the Dividends. In the past I have Topliced or sold out of a Stock because a Market Drop was coming, but it meant I was selling my Winners too early and I don’t think this was such a bright idea.
Another big benefit of Hedging is that it is quick and cheap. I have written about this in the Hedging Blog, but the essence is that if you think Markets are going to fall and you sell a load of your Shares or you TopChop them, then it takes a fair bit of time and you are running up loads of Dealing Fees. Following the Drop, when Stocks are starting to turn up again, you then have to come in and get buying Stocks again (you might buy the same ones back or whatever) - but again this takes time and effort and costs lots of Money on Dealing Fees and Spreads etc. It is also not all that good in terms of timing - it might even take you days to decide what to buy and to get the Money into the Market and working for you - by which time you have missed out on lots of Upside.
By using Hedging, as soon as the Market looks Toppy you can instantly whack a Short Position on a suitable Index, and it is like you have Sold a huge Chunk of Stock in one quick and easy action. As the Market falls, you are then making some Gains on the Downside to help offset the Losses on your Long Portfolio, and once the Falls stop and you think things are turning up, you can instantly Close the Short Position and it is like you have just bought a Huge Chunk of Shares.
Well, that’s the Theory anyway…….of course in practice it tends to be a bit more complicated.
Having said all that, I do think it is a valid approach to lower Downside Risk that is likely to result from difficult Market conditions which are easily foreseeable. For example, early on in 2016 I sold quite a bit of Stock and did some Topslicing and sold out of many of my Overseas Unit Trusts in order to lower my Total Exposure to the Markets. This was really because I knew the Brexit Vote was coming and I felt that it had the potential to be a seriously harmful event on the Markets and I wanted to lower my Risk in this event. Of course it has turned out that I was very prescient in doing this - although it might have been more by Luck than Judgement.
I haven’t checked, but I am pretty sure that if you read ‘Wheelie’s Xmas Message’ blog from December 2015, you will probably find me mentioning the impending Brexit Vote and I know I discussed it on several Podcasts with Justin.
In the converse of this kind of action, when I anticipate that we could have better Markets, I will quite often increase my Total Exposure a bit so I can max out on the Upside Risk that I think we will experience. I might well do this as we move into the final 2 months of the year - let’s see how it goes. I remember I did exactly this in December 2015 to take advantage of the usual ‘Santa Rally’ and I put a Long FTSE100 Spreadbet on which worked pretty well.
Portfolio Specific Downside Risk
“Hang on Wheelie, you never mentioned that one before !! What you playing at?!!”
I wanted to concentrate on the Stock Specific and Market Specific Downside Risks because I think these are ones we can do something about. However, with this new type of Downside Risk that I have just conjured up from nowhere, I am not sure there is much we can do about it !!
Portfolio Specific Downside Risk is a consequence of the make-up of the Stocks in your Portfolio and arises irrespective of the Markets and maybe it is more to do with the Stocks you hold. For instance, over much of 2016 I have been suffering myself greatly from this phenomenon - the Markets in general had been rising and most of my Stocks were doing ok, but my Portfolio has had the worst start to a Year that I can ever remember. So what is happening is that the Stocks I hold and in the Proportions in which they make up my Portfolio, are suffering from a huge amount of Downside Risk. Probably about a third of the hit I have taken so far this year is from a very poorly timed Short Position on the FTSE100 to Hedge my Portfolio from Market Downside Risk but the other two-thirds is generated from the Stocks I hold - in real terms, I have been hit by a succession of Profit Warnings on several of my Stocks - particularly on TSTL and SPRP as I mentioned earlier.
I guess I could call this Portfolio Specific Downside Risk ‘Rough Patch Downside Risk’ - I really think this is what it is, I am simply going through a Bad Patch on my Portfolio and thankfully at the time of writing the First Draft of this blog, my Portfolio has recovered a lot from its worst point of the Year so far (although when I am now finishing this blog off, we have just had the Brexit Vote fiasco and my Portfolio is looking quite ropey again.)
Earlier I said that I didn’t think much could be done about this sort of ‘Bad Patch’ Downside Risk, and I think that is very much the case. I really think the only ‘cure’ for such a difficult period is to ‘stick to the knitting’ and carry on with my Approach which I know has worked for many many years - now is no time to panic and I think Time will be the key factor in improving my Returns for this Year. However, so far 2016 has not been easy so there are no guarantees that I can turn things around.
Everything I have written in this Blog so far could be seen as quite Theoretical, Logical, Rational, Prescriptive, Therapeutic (hey?) etc., however, something that must not be forgotten is the role that Lady Luck can play in how a Portfolio evolves over time.
Luck can be both Good and Bad and can affect us at a Stock level and at the overall Portfolio level - just like with how Downside Risk (or Upside Risk) can hit us from nowhere, so can Luck. Risk can often be something we can have a reasonable understanding of - certainly in terms of its cause if not its magnitude - for instance, the Brexit Vote brings a certain amount of Risk. However, Luck can hit us completely Out of the Blue and a simple example of Good Luck would be when one of our Stocks receives a Takeover Bid which we were utterly not expecting and the Shares shoot up.
To a large extent Luck can just be seen as another form of Risk - again we want exposure to Good Luck (similar to Upside Risk) but we would rather avoid (or more realistically reduce/manage) Bad Luck (similar to Downside Risk) - so the mitigations are exactly the same. However, by having a well established and proven approach which you follow in a disciplined manner, I am sure you can make your own luck !!
You might have read this Blog closely enough to recall that at the start I mentioned how I was sort of concerned that it would be repetitive of other stuff I had written or talked about in the past - luckily, once I actually got on with writing it I found that there was a lot more to the subject than I had originally thought and hopefully Readers found it worth reading - I certainly am pleased I bothered to write it as it clearly has a place within the WheelieBlog Archive for future generations to discover !!
Hope you are still awake,