Some Ponderings on Risk

I often describe how I think of my role running this little portfolio as being the Chief Risk Officer, rather than the Chief Investment Officer.  That may well sound silly to some (and perhaps rightly so), but the way I think about it is that my job is to take good risks (and the investment returns will fall where they fall) rather than to make good investments (it’s amongst one the many reasons I don’t really think of myself as a deep value or value guy).  Paradoxical, I know and a deeper subject for another time.

Risk is one of the topics that I obsess over, as any long-time reader probably realizes, thus what better excuse to scrawl down some ponderings on risk both generally, and with regards to the broad portfolio make-up.

Risk Management vs. Risk Control
During my shortish career I’ve been fortunate to be able to spend a lot of time with a number of investors talking about their strategy.  Something I’ve gleaned from these conversations and always found helpful is the subtle difference between what I call risk management and risk control. 

Risk management, to me, is everything you do before you put a position into the portfolio including the research on it, the consideration of the risks involved, and the sizing of the position.  I’d say it’s the most under-rated part of investing, and it certainly requires the most thought.  One of the reasons is because it reflects the difference between having an opinion and how you execute it; too much of the investments business is centered around peoples’ opinions, when in my opinion the ability to execute these opinions efficiently (so that you make lots of money when right, and lose only a little when wrong) plays the key factor in generating returns. 
Risk control, on the other hand, is what I think happens after the position is in the book; the readjusting, selling, adding, etc to a position.

I make the distinction because doing a better job of risk management requires a lot of proactive and wide-ranging thought before putting a position on to understand the risks involved.  Furthermore, if done well, it should limit the number of occasions when risk control comes into play.  I think that’s important because risk control is more likely to come as a reaction to some particular event, and as such is more likely to be a judgment based on emotion rather than rational though – something which I suspect, and much behavioural finance tries to show, leads to worse decisions. 

How the NCAV Bucket affects the portfolio
One of my (many) flaws as an investor results from this focus on risk; I’m more comfortable underperforming in bull markets than I am losing money in bear markets.  It’s also one of the reasons that I like having the NCAV bucket within the portfolio.  The reasoning is simple; the size of the NCAV bucket is likely to be negatively correlated with the portfolio’s exposures.  Or more simply, as the market rises one would expect the number of names in the NCAV bucket (and hence the allocation to it) to fall, reducing the portfolio’s equity exposure.  Similarly, as the markets falls more names should meet the NCAV criteria and be added to the bucket, meaning the allocation should grow.

Why do I like that? 
Simple; I can’t short and thus my short exposure comes from using puts, which means as the market falls, the delta expands and my short exposure increases.  The additions to the NCAV portfolio partially offset this, especially early on during larger falls or if the falls in the market turn out to be no more than dips.  The downside of course is that the negative performance impact is likely to be reasonably noticeable in a down-market, especially one that sees a noticeable shift away from risky assets (like the micro-small caps that the NCAV screen typically throws up).  However, my hope is that as NCAV is a measure of absolute value (comparing a firm’s market cap to its balance sheet) rather than a relative value measure (e.g. P/E, EV/EBITDA, etc) these will merely be mark-to-market losses rather than more permanent impairments of capital (which would most likely be caused by write-offs and a reduction in balance sheet value).