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Market Turbulence and Portfolio Fine Tuning

Markets are in turmoil once again as the “Greek Tragedy” continues to play out on the European stage. German and French banks are girding for a possible default, and the fear of the contagion spreading to the weaker member states of the Eurozone is freezing investors in their tracks. Stock markets are down on a global basis, a reflection of how interconnected our companies and markets have become in this new age of globalization. Some investment advisors are telling their clients to avoid the risks of the moment and stay in cash or other assets considered safe in these stressful times.

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As markets worsen, what is a long-term investor to do? The first reaction should be to ignore your emotions, pause, and remember your best advice for managing your portfolio in a prudent fashion. With bad news filling the airwaves everyday, it would be very easy to react impulsively. Experience tells us that times like these are when are our biggest mistakes can occur, if we allow our emotions to get the upper-hand.

It was none other than Warren Buffett that often noted that it does not take “a stratospheric IQ, unusual business insight, or inside information” to invest successfully over a lifetime, but you must have “a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework.” Simple and sound advice is always welcome from someone that knows what to do from experience. Remain calm and withdraw from the fear. Now is the time to review your current investment strategy and anticipate any modifications that would be warranted.

As the markets continue to search for their eventual bottoms, wisdom tells us that bargains will be available at some point in the process. Preparing for that event means having cash on hand from an investment perspective or net working capital if you operate a small business. Review your diversification objectives and determine if your holdings are aligned with your goals. At a minimum small investors, according to most studies, should hold thirty or more stocks to ensure a desired level of diversification. Owning the entire market through a very broadly diversified, low cost, passively managed investment fund is even better.

Index funds and ETF’s tend to be an excellent new way to achieve instant risk spreading. If you have losers that have hit your selling criteria, decide at what point you want to convert them to cash.

Many consumers that have significant investment portfolios also have small business interests that should also be subjected to an intensive review to create additional working capital. Flexibility equates to having funds on hand. Make sure that lines-of-credit have been arranged for safety-net purposes or that newer sources, like a small business cash advance, have been researched and put in place. With business concerns properly addressed, attention can then return to fine tuning your long-term investment strategy.

While active investment management is not recommended for the average investor, those who want to play that game must determine whether they can buy bargains on high-dividend paying stock, on growth stocks, etc. Preparation will be key to ascertaining which sectors should receive your special attention. The focus is not to become a “trader”, but to employ good trading principles for entering the market. Buying on the dips may provide immediate savings on the front end, but academic studies show that both amateurs and professionals who time the market tend to achieve inferior risk-adjusted results.

For those who believe in technical analysis, indicators may assist in this process to optimize entry points, but there is never a need to be too aggressive. Active investors must take what the market gives them. They should set a long-term performance objective for each purchase, as well as a price level where a pruning would be advised. When markets are in turmoil, cash can be king. Convert your losers to cash and research small business cash advances so that you will have flexibility when you need it.

Contributed by: Tom Cleveland, September 12, 2011

Market Turbulence and Portfolio Fine Tuning

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  1. Risk management, as the authors define it, delineates for the management of a firm the risks and returns of every strategic decision at the institutional and transactional levels. It indicates how the management must change a particular strategy with the goal of aligning the trade-off between risk and return with the optimal long and short-term goals of the firm. If one desires an in-depth quantitative understanding of risk management as it is practiced at the present time, this book offers a comprehensive and useful overview. Although the authors are clearly showing bias towards a particular tool used for risk management, namely the Kamakura Risk Manager @ product which they helped to develop and market, the reader still gains insight into the relevant factors that go into successful risk management and will understand just how challenging this field is. The book is geared towards the student, for there are usually exercises at the end of each chapter. The goal of the book is very ambitious, in that the authors attempt to integrate credit, market, and operational risk, along with asset and liability management, performance measurement, and transfer pricing into a single framework. The justification for this integration is given as the book unfolds, and because of this the reader may frequently feel impatient, and thus tempted to skip ahead. However, readers who do this will miss out on the interesting argumentation and historical analysis the authors give, with each chapter setting up next. There is therefore a heavy dependence between chapters, and this makes a “skim read” more difficult, at least from the standpoint of in-depth comprehension of the subject matter. Those readers who are not experts in risk management, such as this reviewer, but who have a sound background in probability theory, stochastic processes, and financial engineering (at the level of the Black-Scholes model) will find this book ideal. Options theory plays a central role in the book, as the authors propose that the Jarrow-Merton put option is the best comprehensive measure of integrated credit, interest rate, and foreign exchange risk. The authors believe that risk management should make no distinction between credit risk, market risk, operational risk, asset and liability management, performance measurement, and transfer pricing.

    The authors begin the book by discussing the difference between risk management from the standpoint of net income and from the standpoint of mark-to-market, and how a failure by some financial institutions to adopt the latter caused them great pain. Their historical commentary on this topic is enlightening for it gives insight into some of the biases concerning risk that exist even at the present time. For this reviewer, one of the most interesting discussions in the book concerned the transaction cost approach to prepayment modeling in asset-backed securities. In this approach, the authors divide the borrowers into three classes, with the first being those who make prepayments even when they should not. The second class are borrowers who prepay at a time when the advantages of prepayment exceeds the transaction costs of doing so. The third class are those borrowers who make prepayments when advantageous to do so, even though in the past they have refrained from doing so. Following the book’s paradigm, the authors formulate the prepayment model in terms of options, with the value of the option to prepay being calculated from observable market data. The authors claim that this approach fits the movements in loan prices better than the approaches based on prepayment speeds and prepayment tables, but they do not offer explicit evidence for this claim. In fact throughout the book there are many instances where the authors do not offer any real case studies that would illustrate the superiority of their approach and the use of the Kamakura Risk Manager@. Risk analysts and managers will insist on the availability of these studies before committing themselves and institutional resources to this product or any others that make such claims.

    The book should not be viewed therefore as purely a “theoretical” overview of risk management techniques. The authors give examples illustrating the main principles. For example, in their discussion of one-period models they assert that a collection of homogeneous risks are not sufficient, since the likelihood, magnitude, and timing of risks are closely linked. As examples, they quote the debacles in the U.S. Savings and Loan and Long Term Capital Management, and the takeover of Security Pacific Corporation by Bank of America. They also give examples of ‘selection bias’ in measuring risk.

    Many interesting questions are addressed in the book, such as: 1. Why are ‘fat-tailed’ events important in risk analysis? 2. What is ‘transfer pricing’ and why is it useful? 3. Should risk be measured in terms of the volatility of the mark-to-market value of the relevant portfolio or in terms of the volatility of the net income? 4. How large should risk limits be for each part of a financial institution? 5. How is the mark-to-market value of a portfolio measured? 6. How is tracking error measured? 7. How is a hedging strategy to be priced? 8. What advantages, if any, are there in using Monte Carlo simulations of returns over a chosen time horizon? 9. What are the implications to credit risk of the new Basel II accords? 10.Why are stress tests important in a hedging strategy? 11.What area of the financial organization should be responsible for credit risk?

    The authors also give a thorough discussion of yield curve smoothing, and how to derive the zero-coupon bond prices from observable data. The method of splines seems to be their preferred method of choice as a smoothing technique, which they advertise as being one that allows the calculation of zero-coupon bond prices for a large number of payment dates. They show, interestingly, that a cubic spline of zero-coupon bond yields is the smoothest yield curve.

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