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Protect Your Portfolio Against Risks

Uncertainty in the market is increasing, which means that investors want to insure themselves against risks. Hedging is one way to protect a portfolio against losses. Hedging with options is a popular method that has a lot of shortcomings. A market-neutral portfolio is a hedging method in which the distinguishing feature is the lack of correlation with the market. A market-neutral portfolio enables investors to make a profit when the market takes a nosedive, but this method has to be used carefully. It’s not uncommon to hear that there is a bubble forming in the market. The more a market grows, the more participants start to voice such concerns and the more convincing their arguments sound. However, aside from bubbles such as the dotcom crash in 2000 or the crisis of 2008, there are other situations that impact investors negatively. The slowdown of the Chinese economy, the crisis in Greece and the expectation of increases in interest rates are all factors of uncertainty that put pressure on the market this year. The increase in uncertainty on the market means that a lot of investors want to insure themselves against risks and retain profits made during years of rapid growth. The simplest way to protect yourself against risks is to have a cash position. This position is the least affected by risks and allows investors to take advantage of the opportunities that may present themselves if the market crashes. For example, the recent Flash Crash allowed market participants to purchase stocks of great companies at low prices. Nonetheless, cash positions have one major disadvantage – during periods of market growth, they significantly limit potential returns. Hedging is another way to insure a portfolio against risks. A hedge is a position in an instrument that serves to decrease potential losses on a position in another instrument. Hedging with options is one of the most popular ways to hedge. Options can be used to create all sorts of different hedging strategies. Let’s look at a few basic examples. Protective puts . One of the simplest hedging strategies – the purchase of put options with a strike price at the level of tolerable losses. Let’s look at a scenario in which an investor purchases a stock for $100 and in which the amount he/she is willing to lose is 15%. After purchasing a put option with a strike price of $85, the investor will ensure that the most he or she will lose is 15%. The investor is paying a premium when he/she buys put options – essentially paying for insurance against risk. Collar . The premium an investor must pay to purchase a put option can be quite large. The system of hedging a portfolio with a collar allows to decrease these risk insurance costs. In this strategy, the investor simultaneously purchases a protective put and sells an out-of-the-money call option. By selling the call option, the investor receives a premium that can cover part of the expenses for purchasing the put option. In some cases, the premium received from the sale of a call option can be higher than the premium spent for the purchase of the put option. Thus, the investor essentially gets paid for hedging their position. However, in selling the call option, the investor limits potential income from the long position. This is why the collar strategy only makes sense if the investor expects the price of stocks they purchase to not exceed the strike price of call options they sell. In spite of the popularity of these strategies, hedging with options has a number of serious disadvantages. First, the options market is too difficult to navigate for many individual investors, which is why they prefer to not trade instruments they don’t understand. Second, liquid options don’t exist for all securities, or premiums on the options can be very high. Options strategies described above help to limit losses of the portfolio. But smarter way of hedging is reducing the exposures of the portfolio to different kinds of risk. A better hedge is one that would not only cut down on potential losses, but would eliminate a portfolio’s correlation with the market and other risk factors such as sector specifics (this is relevant, for example, for the Energy sector, which dropped significantly when oil prices fell). A market-neutral portfolio is one such hedging strategy. The idea behind a market-neutral portfolio is that the investor takes a long position on a number of instruments in the portfolio, and shorts the rest. In this way, if the portfolio is put together correctly, there is an opportunity to make profits regardless of how the market behaves. The most popular example of a market-neutral portfolio strategy is pair trading, which is when an investor takes long position in one stock and shorts another (with different weights) in case of widening of spread between their prices. The expectation is that the spread will eventually be become narrower. Pair trading is quite simple in theory, but difficult to carry out in practice. In order to be implemented successfully, investors have to find the right pairs to pair trade. It is best to have more than one pair so that a potential loss on one would be covered by profits from the others. Moreover, it is necessary to determine the weights on long and short positions in each pair, since the securities can have different beta coefficients against the market. Pair trading opportunities do not come up systemically, which is why an investor has to constantly monitor pairs – not a good strategy for those who prefer to only trade occasionally. There has to be a stop-loss for each pair, since the difference between each pair may never diminish, but rather continue to increase in the future. Finally, broker commissions for short positions may make opening a short position on a security in a potential pair impossible. A much simpler implementation of the market-neutral portfolio strategy is as follows. The investor longs stocks and shorts index futures (with adjustment for the beta of the long part of the portfolio against the index). This portfolio would have a correlation with market that is close to zero because of the short part. Profits will depend on how much better than the market the long stocks perform on a risk-adjusted basis. In other words, this portfolio will allow the investor to extract the alpha of securities in the long position. With the development of ETFs, constructing such portfolios has become a lot easier. Instead of shorting futures (the price of E-mini futures does not allow investors to use them to hedge small portfolios), inverse ETFs can be used – ProShares Short S&P 500 ETF (NYSEARCA: SH ), for example. Moreover, sector risks can be hedged by using sector ETFs as hedges. An investor could profit on recent biotech plunge by hedging portfolio of best biotech stocks with iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ). An important advantage of this portfolio is the fact that it does not require a large number of trades. All the investor has to do is occasionally correct the size of the position in the hedge to make sure that it doesn’t differ too much from the long position (with respect to the beta). Here is an example of a backtesting of implementation market-neutral portfolio strategy. We conduct backtesting, starting on 01/01/2008. The backtesting period’s start date was set to 01/01/2008 to include periods of both market decline and market growth. We apply simple screening to choose stocks for the portfolio. On the first step of the screening we limit the universe of 500 US companies with the largest market cap to 100 with the lowest 1-year volatility. On the second step we pick top 20 stocks by dividend yield from 100 stocks that have been chosen on previous step. This portfolio presumably should generate excess return against the market on a risk-adjusted basis. In order to make portfolio “market neutral” we should add hedge to the portfolio. As a hedge we would use short position in SPY. The proportion of assets allocated in hedge should be equal to beta of the portfolio against hedge. Then beta of the hedged portfolio would be equal to zero. In other words, hedged portfolio would be market-neutral portfolio. We would rebalance this portfolio quarterly. Rebalancing is necessary because: It insures that stocks in the portfolio match our screening criteria; It helps to adjust allocation of assets in long and short parts of the portfolio, so that the beta of hedged portfolio would be zero. Beta of the portfolio is recalculated on each rebalancing date. (click to enlarge) At the selected interval, the portfolio has an Annualized Return that is comparable to S&P 500 (NYSEARCA: SPY ). The Maximum Drawdown is much lower, while the Sharpe Ratio is higher. Of course, hedging a portfolio like this is not free. In this case, the price is that a neutral portfolio will show moderate returns during market boom periods. Investing always involves risk: the market is volatile, and this volatility is influenced by both fundamental factors and by noise. Forecasting a market drop is almost impossible, which is why it makes sense to hedge portfolios during periods of uncertainty in order to avoid significant losses. A market-neutral portfolio is a type of hedging that allows investors to limit losses and make profits in any market conditions, since the profitability of such portfolios does not depend on market shifts. But during market booms, such portfolios will be less profitable than regular ones. This is why investors with moderate risk tolerance can employ this hedging strategy periodically, when uncertainty is high.

Was Dalio Risk Parity Strategy Responsible For Recent Turmoil?

Within minutes after the opening bell on Black Monday, August 24, the Dow plummeted 1,089 points, surpassing even the flash crash of 2010. Dramatic declines caused stocks and exchange-traded funds to be automatically halted by stock exchanges more than 1,200 times. The market remained volatile in next weeks also, pulling down both the Dow and the S&P 500 indices down by more than 6 percent in August. The risk parity strategy, pioneered by Ray Dalio, the founder of world’s largest hedge fund, came under fire for this market volatility. The risk parity investment strategy was developed and first adopted as All Weather Fund in Bridgewater Associates in 1996 and has become increasingly popular in the industry. This has been one of most successful investment strategies since last two decades. But its recent performance has been poor. Of late some analysts and fund managers such as Lee Cooperman of Omega Advisors have started blaming the risk parity strategy for the market turmoil seen in recent weeks. This pushed Dalio to a defensive position, prompting his firm to come out with a report for its clients defending his risk parity approach. The Bridgewater report tries to dispel many of the concerns surrounding risk parity and the All Weather fund. Let us see what this risk parity strategy is, how it works, what blames are and what Dalio wants to say. What is All Weather risk-parity strategy and how does it work? The risk- parity strategy is Bridgewater’s flagship strategy, known as All Weather strategy. It is one of the two investing strategies consistently followed since last two decades by Bridgewater Associates, the world’s largest hedge fund with $170bn in assets under management. While the Bridgewater’s other strategy, known as Pure Alpha, is a traditional hedge fund strategy, All Weather is a risk-parity and leveraged beta strategy. It is based on the philosophy that there are four basic economic scenarios: rising or falling growth, rising or falling inflation. And different class of assets behave differently in each of these economic scenarios. The risk-parity’s objective is to reduce the volatility of investing in assets that normally move in the opposite direction in different economic environment. The All Weather strategy allocates 25% of a portfolio’s risk to each of these scenarios. It is allocation of risk and is different from allocation of assets. The portfolio makes money in any economic environment and is considered as a solid strategy in both good and bad markets. All Weather has given 8.95 percent average annual return since its inception in 1996. Its long-term success has helped the industry expand. But this August, $80bn “All-Weather” risk parity fund lost 4.2 per cent and is down nearly 5% YTD. The famous all weather strategy is facing rough weather from critics. What are blames on the risk parity strategy? First, the risk parity strategy allocates assets based on volatility. The ‘smart beta’ passive equity strategies adjust their exposures according to algorithms in response to market moves. The risk parity funds and momentum investors known as CTAs are typically computer driven. Any in volatility can trigger a rash of automated selling. Second, the risk parity strategy involves use of leverage, derivatives and borrowed money, to amplify their bets tied to the performance of bonds, stocks and commodities. Fund Managers often shift their allocations of assets to maintain an equal distribution of risk. They invest passively in a range of financial assets according to their mathematical volatility. In August as volatility increased, these funds are accused to have begun selling with increased intensity. The selling created more selling. This effect then cascaded through markets, and asset correlations increased. As a result assets like stocks and bonds, which often trade in opposite directions, began to fall at the same time. Market collapsed. The risk parity strategy too underperformed. What does Ray Dalio say in defense of risk parity strategy? The inventor of risk parity strategy, Ray Dalio, strongly defends his strategy and Bridgewater’s approach amid criticism. While the strategy might occasionally underperform other investment techniques, but it was still the best long-term strategy. Unlike other funds, Bridgewater does not tend to sell assets when prices fall and buy them when prices rise. It does the opposite to rebalance to achieve a constant strategic asset allocation mix. All Weather portfolio is well diversified so as not to be exposed to any particular economic environment. It has no such systematic bias to do better when interest rates are falling compared to that when they are rising. So it is not vulnerable to a bond sell-off. Dalio says Bridgewater is not responsible for the stock market increased volatility seen last month. Relative to the size of global asset markets, the risk parity strategy funds is too small to move market. It is like a drop in the bucket. Allocations are not adjusted due to swings in volatility, and therefore could not have created the market impact. “All Weather is a strategic asset allocation mix, not an active strategy. As such, All Weather tends to rebalance that mix which leads us to tend to buy those assets that go down in relation to those that went up so that we keep the allocations to them constant. This behavior would tend to smooth market movements rather than to exacerbate them,” fires back Dalio in the Bridgewater Report .

How I Created My Portfolio Over A Lifetime – Part I

Summary Introduction. Three ways to build a portfolio. What types of assets to include. Patience and income have been the keys to my long-term success. Conclusion. Introduction Obviously, there are many ways to construct a portfolio and allocate funds across different classes of assets. The method described here is how I do it. Having a set of principles and specific goals helps me to stay on the right path, and I hope my explanation will help readers to formulate a system of investing that works for them. The methods I use as described in this and articles to follow are meant to provide a flexible set of guidelines that can be modified to fit any investor’s needs. If you are just starting out on your lifetime investment adventure, it is important to establish a plan with reasonable, achievable goals and intermediate milestones. I focus on the next milestone to alleviate the frustration that can creep in upon setbacks (which are a natural part of investing). Each milestone is within reach in just a few years, so it is always achievable. Once a milestone is achieved, I just plod on toward the next one. When I was in my 20s and just out of college, I started out with a goal to save $25,000. Back then (in the 1970s), that was a lot of money. I attainted that goal within four years after graduating. The next goals was to double it to $50,000; then $100,000; and each milestone thereafter was to hit the next $100,000. The great thing about having a plan and sticking to it is that it gets easier to achieve each new milestone, especially after hitting $300,000, because you are not doing it all alone. Your money is working for you, too. Or, at least, it should be if you are doing it right. I have to admit here that I strayed from the path a couple of times and got behind. I still had a lot to learn. I was good at saving, but the investing part was not working as well as I had hoped. Initially, I was accepting more risk than I needed to in the hope that I could achieve those milestones faster. In contrast to the now-famous quote of Mr. Gecko from the movie “Wall Street,” greed is not good for most investors. It generally gets in the way of consistency. When you win, you win big; but when you lose, you lose big! If an investment loses 50 percent of its value, it require a 100 percent gain just to get back to even. So, it took me more than a decade to realize what I was doing wrong. Then I read an excerpt from a study that showed how 40 percent of the total return of the S&P 500 had come from dividends when measured over the very long term (as in a lifetime, or 30-50 years of saving and investing). Suddenly it dawned on me that by looking solely for appreciation, I might be missing as much as 40 percent of the potential that the stock market had to offer me. That was revolutionary and so began my investment approach evolution. One other thing happened during my formational period. A married couple with a new baby, friends of mine, came to me with a question: If I had a baby (which I did not at the time) and wanted to put away money for his/her college education, how would I invest it? This is way before 529 plans, so that was not an option. It was also during the early 1980s when interest rates were sky high (like 15 percent for 30-year Treasuries). They didn’t want to invest in stocks. So, I suggested that they invest in zero coupon treasury bonds, then referred to as CATS. They did. I didn’t. They are happy. I am sad. They were able to lock in a 12 percent yield. By the time their baby turned 18 years of age, they were able to sell the bonds they originally bought at a price of $25,000 for well over $200,000. Of course, they had to pay taxes on the interest each year as it accumulated, and then they paid capital gains on the amount of appreciation above the accumulated interest, but that was well worth it. If they had held those bonds for the full 30-year term they would have accumulated nearly $750,000. This sort of investment return is not achievable in today’s environment of artificially low interest rates. But the pendulum always swings and often to extremes, so be ready to jump on the opportunities that are available when they come. The point to all this “experience” chatter is to frame the answer to why I invest the way I do. I invest with a long-term time horizon, even now at age 66. I need my money to last for at least another 20 years for me and my wife. I would also like to leave a nice nest eggs for our two children. Thus, my horizon extends beyond my own lifetime. That is, by definition, long term. And that is how I invest: for the long term and for a rising stream of future income for me, my wife and our children long after we are gone. What is your time horizon? Think about that and make sure you define it well. You are not just investing for when you begin your retirement, but for at least another 20-30 years or more after. Make sure your goals align with those needs. Three ways to build a portfolio There are basically three ways to invest for the long term, in my opinion. This, of course, is predicated on a strategy of buy-and-hold for the long term. If you are trading in and out of stocks like I did before I learned my lessons, there are many other methods and systems to follow, none of which will be mentioned in this article. Sorry, but I am what I am. Buy on the dips Dollar cost averaging Buy only after a bear market Of the three listed above, I mostly use the latter. That is why I wrote a lot of articles until about two years ago when valuations were still cheap, and also why I have not been writing as much for the last two years, as valuations rose to historically dear levels. I am not predicting a crash, although a bear market does seem overdue at this point. We are in the middle of a correction, and I have no idea whether it will turn into a bear market or if the markets will recover to set new records. That is a discussion for another place. But I am collecting my dividends and interest, accumulating cash for the next great opportunity when it does finally come. Buying on the dips has worked wonderfully for investors since March 2009. It is a great way to systematically add quality stocks to a portfolio when valuations are below historical averages. Whenever the stock of a great company slips by more than ten percent (or whatever percent seems appropriate for that stock), buy some more. It is simple and it works during a bull market. But it does not work so well during a bear market. That should be obvious. If a stock falls ten percent and one buys, then it falls another ten percent and one buys, and then it falls some more and more, it can get nerve wracking and one may begin to question their own actions. The long-term investor will be fine over the very long term, but he/she may suffer losses in the short to intermediate term. The market will recover and, assuming the investor has bought high-quality stocks, so will the portfolio. The dividends will just keep on being paid, adding more cash to be invested to create more income. There is really nothing wrong with this method. Dollar cost averaging works in a similar fashion but with a twist. The investor continues to invest the same amount at specific intervals. When the stock is high, one receives fewer shares. When the stock is low, one receives more shares. It is a method that is simple because it takes most of the decision-making about when to invest out of the equation. It does not really optimize investment return, though. And it is also reliant on buying quality companies to hold for the very long term. Even the best companies go through difficult times, but the best of the best evolve with the times and find a way to right the ship. Selectivity is always a key to investing. Why do I generally buy only after a bear market? The simple answer is I like the lowest cost basis I can get. To expand on that answer a little: I prefer to not use trailing stops, so I buy at prices that only come along very infrequently. Why do I not use trailing stops, you ask? Because with high frequency traders [HFT] able to move the markets at the blink of an eye and with the creation of exchange traded funds, the chances of getting an order filled way below the stop prices is way too high. I have friends who got stopped out of long held positions at losses of 30 percent or more on the day of the flash crash on May 6, 2010, even though the trailing stops they used were set at no more than ten percent below the opening price that day. The Dow Industrials Index (DJIA) fell about 600 points in about five minutes and was down nearly 9 percent at its lowest point, only to spring back, recovering most of the loss for the day. There is more to this than HFTs at work here, but that is an explanation for another time or this article will become way too long. I will discuss these varying methods in greater detail in another article with examples included for comparison. What types of assets to include The simple answer is “everything.” The purpose is to achieve diversification. I will explain the purpose and my goals for diversification in another article. The basic rule is that by diversifying across different asset classes, an investor reduces the risk of having everything in a portfolio fall in value at the same time since some assets often move counter to one another. These are the types of assets that I own: Individual stocks ETFs Individual bonds (corporate, municipals, federal government issued or backed) Bond funds Real Estate rental properties Precious metals Should everyone own everything? Not necessarily. I will always maintain that the more one has, the more diversification one needs to hold onto one’s capital. There is also the very real need to be familiar with each class of assets in which one invests. Always stick with what you understand. That is probably the most basic rule of investing, and possibly the best advice I can give to someone starting out. The next piece of wisdom is to never stop learning. By expanding what you know, you will open up new opportunities. It may take years to achieve a level of comfort necessary to actually add a new class of assets to your investment portfolio, but the patience and time it takes to gain the knowledge are worth the wait. As you understand more about each asset, you will also understand that there are better times to invest in each one. Recognizing the best time to invest in a particular asset is important. It also requires patience, a theme you will read throughout many of my articles. Of course, it is possible to invest in just stocks and bonds and cover most of the bases. To get exposure to real estate, one can invest in real estate investment trusts (REITs). To gain exposure to precious metals, one could own gold or silver mining stocks, streamers or ETFs. To gain exposure to bonds, one can invest in bond funds or closed-end funds [CEFs]. There are both benefits and drawbacks to each method of gaining exposure. I intend to get into those issues in another article in this series as well. Promises, promises. I want to spend more time explaining how I allocate my portfolio and how I adjust my allocations across various asset classes in greater detail, but that will need to happen in the next article or two in this series. Again, I am trying to keep the length of each article down to a reasonable level. Patience and Income are the keys to long-term success This is my guiding principle. It may not be yours and that is fine, too. But as I realized that owning assets that pay me to hold them can provide me with more cash to invest, I was hooked. Once I realized that there are companies that increase dividends every year, I never looked back. This worked to perfection in the beginning. Then came the first major stock market correction of my investing life, 1987. It was fast. It was brutal. It unnerved me. That is when I learned about diversifying across asset classes. It also reminded me of how well my friends were doing with their CATS bonds so far. I realized that I needed to do something different if I wanted to protect that which I had worked so hard to accumulate. I have a great story to relay to you about real estate, but I think it will require an entire article to do it justice. I now have income streams coming in from multiple sources, and the income rises each year. I plan to keep that as my short-term goal each year going forward. It really helps to focus on the income side of the portfolio during volatile market gyrations. The value can go up or down in the short term, but as long as the income keeps rising, I can feel good about what I am doing. The longer I do it, the more confident I am in what and how I am doing it. Conclusion If you want to be a millionaire, you need to invest like one. Wealthy people do not need the income from investments so they do not need to invest unless there are bargains available. Think about that for a moment. There are bargains available most of the time in one asset class or another. The key is to identify which one offers the best long-term value at any given time. People who are not wealthy feel like they need to keep all of their cash invested all of the time. That is not how Warren Buffett does it. He likes to always have large amounts of cash available at all times. Have you ever wondered why? It is really simple. He likes having cash available for when a bargain appears. He does not invest just to keep his money working. He invests when he identifies a long-term value opportunity that only comes around infrequently. Buffett considers cash as an option on the future. If you have followed his quotes for very long, you will recognize this concept. What he means is that great investing opportunities will always present themselves at some time in the future if one is patient and persistent enough to wait for their appearance. There is so much more I want to cover, so I will try to submit at least two articles a week in the series for the next few weeks or until I feel most of what I want to write has been written. Until next time, do not rely on luck; rely on wisdom and hard work. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.