Risk Management

[weijian]

Hi Temperament,
Actually i kinda agree with freedom over here, but i do understand what you are asking.

I do not have much ideas on elaborate hedging techniques and here's the only 1 i know (it first came from Kenneth Fisher, son of Philip Fisher) I read it some time ago. I wanted to find the weblink again to put here but i couldn't.

I have to also disclose that i only understand the idea, but i have never explored on the details and implementation:

(1) Let's say u r invested primarily in the S&P500. You will choose another index (call it indexA) that is highly correlated to S&P500 but it is more volatile (eg. a small cap index or something that drops more in a bear market)
(2) Buy 'out of the $' put options on indexA.

P.S. This method is like buying insurance to hedge against black swans. If nothing happens, your options just expire and u dont exercise them.

[cif5000]

Hedging is like buying insurance. Why bother if u r rich n u know u will die at 90 in ur sleep.

[Temperament]

You Can’t Hide
{The most damaging types of risk are those that can be attributed to common wisdom or accepted practice. These risks are hidden behind the veil of conventional wisdom, but they are still there. They are damaging because most people do not understand the extent to which they are exposed to the very real possibilities of loss.
Consider the common buy and hold strategy for investing in stocks. This is the strategy that mutual funds are mandated to use by federal law. Buy and hold strategy keep you in the markets at all times. Anyone using buy and hold strategy saw their investment value dip from 35 % to 40 % in just the year 2008. A buy and hold strategy carries significant risks. You are exposed to the full risk that the market will drop in value. (In reality, Unexpected Catastrophe causing severe bear market is not “Unexpected.”)}
The above is an extract from a book about RISKS MANAGEMENT

(Actually, it happened to me in the worst possible case in 09 March 2009. Don’t you think it’s very scary? And I were not really using buy and hold strategy. I were using “Life Cycle Investing” yet I were caught. But with the Lord’s blessing my portfolio was making a little money by 25 September 2009, Amen).

Coming back to the present topic - RISK MANAGEMENT

The question is,
"Don't you think if i learn to hedge by shorting an ETF correlated inversely to my portfolio such that if my porfolio down by 50% it will be offset by the % of hedging i take. Of course on the upside, my portfolio will make less by the % of hedging too.(There is no free lunch in this world, really.)

So isn’t this hedging is like assets allocation or re-balancing my portfolio of stocks? It's even more important to hedge if the Market is in the Bull Run now. You would want to protect what you have gain so far. You wouldn't want to lose back too much to the Market when the Bull suddenly turn into a Bear.

Anyway there is really no free lunch in investment as share by Weijian's
quotation:-
"Investors need to pick their poison: Either
make more money when times are good and have
a really ugly year every so often, or protect on the
downside(i suppose hedging) and don’t be at the party so long when
things are good"

If i am not mistaken, we can short STI ETF for hedging our SGX portfolio.
i am really glad to be enlightened if there is a better way. Put or call option as hedge instruments are too complicated for Simple Simon like me. i never like them at all, anyway. But i have never hedge my portfolio because i am not really sure of the benefit to do so. So can i short STI ETF for hedging my portfolio in a Bull Market? Is there anyone care to share his experience of hedging?
Thanks.

[weijian]

If i am not mistaken, we can short STI ETF for hedging our SGX portfolio.
i am really glad to be enlightened if there is a better way. Put or call option as hedge instruments are too complicated for Simple Simon like me. i never like them at all, anyway. But i have never hedge my portfolio because i am not really sure of the benefit to do so. So can i short STI ETF for hedging my portfolio in a Bull Market? Is there anyone care to share his experience of hedging?
Thanks.

hi temperament,
i think plain vanilla 'shorting the STI ETF' is simply taking a position on the market direction, it is not really hedging.
You have to use leverage (like options) so that the small premiums u pay, will translate to a bigger payout.

[wee]

i am really glad to be enlightened if there is a better way. Put or call option as hedge instruments are too complicated for Simple Simon like me.

If options are too complicated, just sell your stocks. It can't get simpler than that.

Just joking. Seriously, like what some other forummers have pointed out, what you are trying to achieve is a form of trading/speculation on the direction of the market. I don't consider it a risk management strategy. You are trying to get out of the stock market (exposure) during bear phases (provided you can correctly spot it, and get right back in before or close to the upturn).

[Temperament]

Hi, thank you for all who has responded in agreement or disagreement of "Hedging". (i am here to learn from everyone, good or bad, Ha! Ha!)

May i quote the definition of hedging from :-
Hedge (finance) - Wikipedia, the free encyclopedia

{A hedge is an investment position intended to offset potential losses that may be incurred by a Companion Investment. A hedge can be constructed from many types of financial instruments.

A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.}

Unquote:-

So i have SGX stocks only, the best and simplest way to hedge i think is shorting STI's ETF. when my portfolio is enjoying a Bull RUN. So can i buy a "Short STI's ETF" as an ETF? i think there is this ETF besides the normal STI's ETF. As to the % of hedging i am really not sure as i have not done it before.

i consider the current Market not suitable to hedge. In fact i am trying to buy more SGX stocks. i am only interested to hedge if my portfolio is in a Bull Market Run - In order that i can stay in the market until there is crazy, glassy-eye-looks on almost every market players' faces . Which i don't have a chance to experience; Ha! Ha!

i always exit the Market too early due to fear of getting caught from the BUll suddenly turns into a Bear. Imagine how much more profit i can capture if i hedge correctly. i think the % of hedging is critical(it works both ways), besides the financial instrument chosen for hedging.

If i am successful in hedging in a Bull Market Run, i consider myself i have learned a new investment skill. What do you think? May some hedging "SIFU" please show the correct way of hedging?

Thanks.

[KopiKat]

A quote from Warren Buffett,

"Risk comes from not knowing what you're doing."

That's why if you read books on Warren Buffett approach, there's a lot of emphasis on understanding and analysing the business. For example, extracts from the book 'The Warren Buffett Way' by Robert G. Hagstrom,

THE 12 TENETS

Business Tenets
1. Is the business simple and understandable?
2. Does the business have a consistent operating history?
3. Does the business have favorable long-term prospects?

Management Tenets
4. Is management rational?
5. Is management candid with its shareholders?
6. Does management resist the institutional imperative?

Financial Tenets
7. What is the return on equity?
8. What are the company's "owner earnings"? (Owner Earnings = Nett Income + Depreciation/Amortization - CAPEX)
9. What are the profit margins?
10. Has the company created at least one dollar of market value for every dollar retained?

Value Tenets
11. What is the value of the company?
12. Can it be purchased at a significant discount to its value?

Sorry... No short cut here. Still have to do a lot of research and reading...



A longer version of Warren Buffett quote,

‘‘I put a heavy weight on certainty. If you do that, the whole idea
of a risk factor doesn’t make any sense to me. Risk comes from
not knowing what you’re doing.’’

A similar quote from John Maynard Keynes,

‘‘As time goes on, I get more and more convinced that the right
method in investments is to put fairly large sums into enterprises
which one thinks one knows something about and in
management of which one thoroughly believes. It is a mistake
to think that one limits one’s risks by spreading too much
between enterprises about which one knows little and has no
special reason for special confidence. One’s knowledge and
experience is definitely limited and there are seldom more than
two or three enterprises at any given time which I personally feel
myself entitled to put full confidence.’’

[Temperament]

On the other hand(shamelessly) borrow an article posted by CW8888:-

Investment article: What you may not know about stocks?

Below is an investment article by Jeff Augean, extracted from my favorite blog "CreateWealth8888", dated 4 Feb 2011. I like the blog because many of the articles are sensible, informative and educational. Hope readers can benefit from the article:

" Most investors who buy a stock believe that they are investing in a company. That view, while technically correct, is also misleading. A stock investment is really nothing more than a bet on the direction that money will take as it flows through the financial markets. A stock can rise only if market forces align to aggressively drive up the bid price causing new money to flow into the stock.

Many different factors are involved including economic news, announcements from other companies in the same industry, political events, and the actions of large institutional investors, analysts' forecast, and a variety of global economic forces such as changes to currency exchange rates and interest rates. The long-term performance of a stock represents nothing more than the compound effect of these forces over time.

It is important to recognize that the financial markets are zero sum game with competition at all levels. The stock market competes for money against the bond and currency markets; industries compete for money with each other; and money flows between stocks within a particular industry. An individual stock can fall because money is flowing into the bond market. It can also fall because money is flowing into another stock in the same industry. Conversely, the stock of a poorly performing company can rise if market forces are properly aligned. All factors considered, the price of a stock is often loosely connected to the performance of the underlying company.

There was a time, not long ago, when individual investors were the dominant force in the market. Buying a stock was equivalent to betting on the behavior of other market participants. Those days have passed. Today's markets react to economic news in fraction of a second. Heavily traded stocks in the S&P 100 or DOW rise and fall for reasons that are nearly impossible to understand at the individual stock level.

Investors who recognize these complex dynamics can gain advantage because they have a balanced, realized view of the problem. They spend most of their time identifying the underlying forces driving the markets, and they always try to invest with those forces instead of against them. In this regard, the most important attribute an investor can have is humbleness because successful investing is a never-ending struggle"

[KopiKat]

Many different factors are involved including economic news, announcements from other companies in the same industry, political events, and the actions of large institutional investors, analysts' forecast, and a variety of global economic forces such as changes to currency exchange rates and interest rates. The long-term performance of a stock represents nothing more than the compound effect of these forces over time.

If you find the above different market forces easy to understand and analyse, then that's the way for you to go. For me, another Warren Buffett quote immediately pops to my mind,

"I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over."

My understanding is he finds companies (within his area of competence) easier to analyse than the many other things listed above such as economies, political events, exchange rate fluctuations, interest rates,...

[Temperament]

Many different factors are involved including economic news, announcements from other companies in the same industry, political events, and the actions of large institutional investors, analysts' forecast, and a variety of global economic forces such as changes to currency exchange rates and interest rates. The long-term performance of a stock represents nothing more than the compound effect of these forces over time.

If you find the above different market forces easy to understand and analyse, then that's the way for you to go. For me, another Warren Buffett quote immediately pops to my mind,

"I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over."

My understanding is he finds companies (within his area of competence) easier to analyse than the many other things listed above such as economies, political events, exchange rate fluctuations, interest rates,...

Quote:
"Investors who recognize these complex dynamics can gain advantage because they have a balanced, realized view of the problem. They spend most of their time identifying the underlying forces driving the markets, and they always try to invest with those forces instead of against them. In this regard, the most important attribute an investor can have is humbleness because successful investing is a never-ending struggle"

Unquote:
Of course, we all should agree that investment in stocks should be based on principles(WB, Peter Lynch, John Templeton, Anthony Bolton, etc....) or simpler should be based on "THE RULES OF THUMB".(Each of us i believe has his own set of favourites "ROT".)
But i also believe we all consider or is affected by the "Current Market's Sentiment" when we buy or sell. No one in the Market long enough is not influenced or bothered to some extend by the News of European's Economic Crisis or some other countries of the world.
In other words, why do some of us think the current SGX Market is not going anywhere soon? Of course in a twinkling of an eye, anything can happen and the Market reacts very violently, swinging like a pendulum all the way to the right or left. This is the time we are glad we invested, based on our favourite "ROT" extracted from all the Greats of the investment world. And this is also the time based on many Great Investor's "ROT", we are advised to grab the "FireSale", we have being eyeing all the time. Isn't this buying based on Market Sentiment at this time, even advised by the Great Investors
But (at least to me) if we can make use of all available knowledge or resources we can muster, why not?
And i think no one with some experience of the Bear/Bull Market Cycle will invest in the Market without taking "Current Market Mood/Sentiment" into due consideration. This may even be taken as some "form of risk mangement". Ha! Ha! No?