Five keys to mitigate risk

On the Contrary

Although I am not really a baseball fan, one of my favourite movies is Moneyball. Maybe it’s because I love a good David-versus-Goliath story or, in this case, how a small market team was able to outperform those with much larger payrolls.

The reason is that Billy Beane, the general manager of the Oakland Athletics, is a contrarian at heart. He identified a weakness in the way everyone scouted and selected players, thereby leaving opportunities for him to pick up high-quality but undervalued players no one wanted for a fraction of the cost.

“In human behaviour there was always uncertainty and risk,” wrote Michael Lewis in Moneyball. “The goal of the Oakland front office was simply to minimize the risk. Their solution wasn’t perfect, it was just better than the hoary alternative, decisions by gut feel.”

Similarly, investors should be asking the right questions about how they make decisions, particularly as they apply to risk. Are they falling privy to human emotion such as following the crowd or making decisions based on gut feel?

The good news is that by remembering five simple rules when evaluating risk, investors can improve no matter how much capital they may have.

If it sounds too good to be true, it very likely is.

There is no such thing as a hot deal for regular investors. Read the fine print on high interest rate investment products, and avoid those so-called two to three baggers in your core investment portfolio.

Instead, we like the Moneyball approach, which has been summarized by others as: “Go for steady, consistent wins. You don’t have to hit home runs. Just get on base and avoid striking out.”

Assets fluctuate while debt is a constant.

The classic argument for having high debt levels is that they are supported by high asset values. For example, a recent Statistics Canada report suggested that rising asset values in Canada mitigate our record high debt levels.

We find this to be an extremely flawed argument, as leverage is a constant and assets can fluctuate. For proof, simply look at the U.S. housing market collapse in 2008, which left many homeowners owing more on their house than what it was worth.

Always remember that leverage compounds losses as much as it compounds gains. Keep it simple, stupid. We’ve seen investment portfolios with more than 400 stocks, bonds and mutual funds being managed by one stockbroker, using complex multi-class investment products with different features such as conversion privileges and exempt-market private funds with hundreds of nontransparent holdings.

If you can’t understand and track what you are investing in, then you can’t understand the risks.

Have an idea of your downside exposure.

This may mean taking off those rose-coloured glasses and asking your investment adviser if he or she has stress tested your portfolio to see what would happen in a market correction.

Corrections often happen when people least expect them, so being prepared in advance helps preserve capital during such events.

Past performance does not predict the future.

In our opinion, this one has the best Moneyball analogy. Stocks, mutual funds or exchange-traded funds, like baseball players, are often chosen based on their recent performance despite strong evidence that they have zero correlation to future performance.

Why not step away from the crowd and their returnchasing ways, accept that the future is inherently unknowable and manage the risk accordingly.

Finally, like Beane’s use of sabermetrics to identify baseball players, there are some great tools out there to help investors manage their investments. For example, we find options are very useful in adding a level of predictability and stability to a portfolio.

It’s funny how things turn out when one simply tries to get on base rather than swinging for the fence.