Portfolio/Risk management when volatility increases
A comment/question was asked last night about how I how I adjust my trading to changes in volatility. It's a rather thought provoking question and it really reaches to the broader question of how do you manage risk. Portfolio risk has been the subject of much thought over the years and was brought to the limelight with a brilliant paper by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. This paper launched the whole concept of modern portfolio theory.
Essentially, Markowitz proposed that investors should assess the overall risks of their portfolios, not simply the risk of an individual security. He introduced the idea of diversification where a portfolio is invested in multiple instruments whose returns are uncorrelated which, by its very construction, results in reduced market risk.
I do not take this approach primarily because I seek returns that are greater than what such a portfolio would likely offer. Since I always talk about active portfolio management, my thought is to reduce risk by actively trimming losses when they occur; never allowing one position to hurt the overall portfolio by a significant percentage.
Added to this idea, I engage in a different kind of diversification commonly called hedging which is basically offsetting your risk in one area with a negatively correlated offsetting position. These negatively correlated positions change over time in my mind; i.e., they are not always the same. For example, I have been looking to short oil as an offsetting position to my long gold shares. Oil and gold tend to move in the same direction although not a perfect correlation by any means. In fact, at this juncture gold is much strong than oil and oil appears that it could retrace after its first bounce. Since gold has just had a big move and longer term swing points are directly ahead and since I don't care to close out these long gold shares, a short in oils could serve as a counter play to the metal stocks cushioning any weakness there with weakness in oil.
Another way to circumvent volatility is to play smaller and to work trades on differing time frames. The example above is a desire to hold gold shares longer term and to cushion them with shorter term hedge trades.
Essentially, Markowitz proposed that investors should assess the overall risks of their portfolios, not simply the risk of an individual security. He introduced the idea of diversification where a portfolio is invested in multiple instruments whose returns are uncorrelated which, by its very construction, results in reduced market risk.
I do not take this approach primarily because I seek returns that are greater than what such a portfolio would likely offer. Since I always talk about active portfolio management, my thought is to reduce risk by actively trimming losses when they occur; never allowing one position to hurt the overall portfolio by a significant percentage.
Added to this idea, I engage in a different kind of diversification commonly called hedging which is basically offsetting your risk in one area with a negatively correlated offsetting position. These negatively correlated positions change over time in my mind; i.e., they are not always the same. For example, I have been looking to short oil as an offsetting position to my long gold shares. Oil and gold tend to move in the same direction although not a perfect correlation by any means. In fact, at this juncture gold is much strong than oil and oil appears that it could retrace after its first bounce. Since gold has just had a big move and longer term swing points are directly ahead and since I don't care to close out these long gold shares, a short in oils could serve as a counter play to the metal stocks cushioning any weakness there with weakness in oil.
Another way to circumvent volatility is to play smaller and to work trades on differing time frames. The example above is a desire to hold gold shares longer term and to cushion them with shorter term hedge trades.
posted by Tat | 8:56:00 PM
|
1 comments
