Strategy: Greg Hoffman Toolkit to assess risk
When markets have been kind, it can be easy to forget the dangers that might lie in store
The excellent book A Man for all Markets was the focus of May’s column. It’s by card-counting and investing guru Edward O. Thorp. I covered some of the book’s lessons previously but there is one key aspect to Thorp’s success that I want to focus on here, and that’s risk. Comparing his gambling career with his time in the investment world, Thorp writes: “Each requires money management, choosing the proper balance between risk and return. Betting too much, even though each individual bet is in your favour, can be ruinous… On the other hand, playing safe and betting too little means you leave money on the table.”
Many outstanding investors advocate concentrating your portfolio heavily on your best ideas. It’s an approach I believe in, but it carries serious consequences if you get it wrong, which is why risk management is so important.
In this column, I’ll share a four-step process for portfolio construction, incorporating the concept of risk weighting. The first two steps are focused on valuation, while the final two introduce the overlay of risk.
1 UNDERPRICED. ALWAYS
The most important thing is to only buy and own investments that are underpriced. Overpriced investments are never welcome in the portfolios I manage, even if academics insist they add diversification. I’d rather hold cash than an overpriced position.
While this might seem to be part of the “return” side of the equation, there is also an element of risk management. Overpriced investments always present an element of price risk. Even in a rising or flat market, expensive individual stocks can fall. Just ask the owners of former darlings such as Blackmores and Bellamy’s.
2 RANK BY ATTRACTIVENESS
The second step is to rank the underpriced stocks you’ve identified in order of attractiveness. The level of underpricing is a subjective but necessary call. A concentrated investor only has a handful of large positions available in their portfolio, so they must be saved for the most attractive investments.
The definition of “attractive” is also somewhat subjective and can change over time. In a bear market, it may simply be the stocks I believe offer the most upside. At the moment, more than eight years on from the bottom of the last bear market, downside protection weighs more heavily on my list of attractiveness than making a killing.
3 ENVISION POTENTIAL RISK FACTORS
Now it’s time to bring risk into the picture by imagining and running through risk factors. Warren Buffett said it well 10 years ago when looking to hire a successor to manage his company’s investments. One of Buffett’s key criteria was, with his emphasis: “Someone genetically programmed to recognise and avoid serious risks, including those never before encountered.”
I spend a lot of time researching and thinking about various risk factors (some opposed to each other) that might emerge. A sample of the risks I overlay on portfolios to test for exposure include pandemics, terrorist incidents, recessions, inflation, deflation, a property market crash, another financial or banking crisis, a 25%-plus fall in the sharemarket or severe drought.
4 CONSIDER RISK CORRELATION
The final step is to consider the correlation of risks that the most attractive stocks on my list are exposed to. Here’s a list of hypothetical investments ranked purely by their level of underpricing:
1. Mining stock A (60% underpriced) 2. Mining stock B (50%)
3. Mining stock C (40%) 4. Supermarket retailer A (35%) 5. Medical stock A (35%)
6. Medical stock B (30%)
7. Mortgage broker A (25%) 8. Medical stock C (20%)
9. Specialty retailer A (20%)
10. Infrastructure stock A (15%)
Underpricing is no guarantee of a good outcome
A concentrated portfolio constructed from this list might look like the chart at right. The two key aspects of this portfolio are that higher allocations are made to the more underpriced stocks but that risk factors are carefully taken into account.
For instance, you can see that Mining stock C and Medical stock C have been omitted altogether, even though they’re more underpriced than stocks below them on the list. That’s because underpricing is no guarantee of a good outcome. Every stock has risks and you don’t want to be over-exposed to any single risk factor or sector.
As Thorp explains: “Betting too much, even though each individual bet is in your favour, can be ruinous”. As a concentrated investor, my top priority is avoiding ruin (losses from which the portfolio is unable to recover). Part of my protection at this point is holding a hefty amount of cash. Relative to a more normal level of 5%-10%, I’m currently in the 15%-20% range given recent favourable market conditions.
KEEP MONITORING
Another practical tool you can use is a matrix, like the one in the table below. It lists the stocks in your portfolio on one axis and various risks on the other. Then, next to each corresponding stock/risk box you indicate whether the given risk factor would be a positive, negative, neutral or “don’t know”.
There are several benefits to this approach. First, it forces you to confront the various risks your portfolio faces. This is especially timely when we’ve been in relatively calm financial seas recently. Second, it encourages you to think of as many risk factors as possible and go through the healthy thought experiment of considering their impact on each of your investments. Of course, this involves a high degree of informed estimation. Third, it allows you to see which risk factors you’re most exposed to. You might also make some improvements to the table (for example, you may be able to visually represent the weightings in each stock by colour coding or even changing the size of the rows).
Importantly, this approach is not about predicting risk. It’s about making sure you’re prepared for the outcome of a wide range of events and ensuring that you’re not going to suffer financial ruin from any one of them.