The Game of Risk

By Bob Wood, Muslim Media News Service (MMNS)

Investors today seem to view building and managing their portfolios as overseeing a basket of financial assets. And while that is true to some degree, a different tack may prove more useful, considering the disappointing long-term performance record that average investors achieve. Perhaps, they should, instead, imagine that they are managing a basket of risks. In today’s volatile market environment, that approach may be easier to understand than it has been in the past.

By now, you are aware of what has been roiling stock markets around the world. Bond markets everywhere are shuddering from the sudden realization that many bond portfolios held something other than their owners were led to believe.

Rather than a basket of investment-grade debt obligations, many bond portfolio owners suddenly realized that their holdings amount to nothing more than low-grade junk bonds. But some big problems are now compounding this difficult situation. The first involves the fact that investment grade bonds always offer yields lower than junk bonds, because of the relative assurance that a high-quality debtor is very likely to pay his loan as agreed. But with the rapidly rising potential for so many of these bonds to yield nothing, due to rising mortgage defaults, no one seems willing to offer any price to those selling them.

But here is what is troubling even to stock market investors: what is affecting the much larger bond market will, at some point, spill over to stocks. And this concern Includes those deeper issues suggested by today’s turmoil in the bond markets. First is the trouble brewing in the economy in general, since so many borrowers are considered in danger of failing to pay their debts. And second, those losses in nominal terms are estimated as staggering, after recent reports of losses from large investment banks like Bear Stearns and, most recently, several well known hedge funds.

The size and owners of these losses are still unknown. But the potential is great for this problem to feed on itself and cause lower bids for higher quality bonds. So, even lenders who acted responsibly may well be dragged into the mess.

To compound the problem, less responsible lenders have seemed to view the risks in owning someone else’s debt as so minimal that they saw adding more risk in the form of leverage as a great way to boost returns. After all, how risky does a high-grade bond fund sound to you? It shouldn’t expose the holder to much risk at all, unless of course, those risks were priced incorrectly at the start.

Imagine now owning a portfolio of junk bonds with an expectedly high rate of defaults. Then imagine adding leverage at three to five times the original investment. Now you have an idea of what we think of as low-risk investing becoming very high risk — in a hurry. Add to that a fear of the unknown, such as wondering how deep this problem will go and how wide the swath of damage will be, and this has created uncertainty in the markets. When variables become less certain, how is price risk set for any asset class, including stocks?

So what you have now, rather than a basket of stocks or mutual funds, is a basket of various risks. And your job becomes, not just keeping an eye on your holdings and re-balancing from time to time but, managing a basket of disparate risks and pricing them, not based on future cash flows or dividend payouts but, according to your risk of loss.

So how confident are you about the risks involving holdings in your portfolio? Have you determined how investor behavior can affect your holdings in the short run? By investor behavior, I am suggesting two emotions that always come to the fore: fear and greed.

We see greed at market tops. Think back to the late 1990s and recall how investors loved their high flying technology stocks and mutual funds. Think, too, about the mad rush to buy real estate as short-term investments in 2004 and 2005. But, when investors realize they may have paid too much for what they now hold and cannot sell at a profit, fear replaces greed.

Fear was rampant in the stock market as it bottomed in late 2002 and early 2003. Impatient investors really didn’t bother to consider if what they held had positive long-term potential. But then the calls went out to brokers and advisors to sell. When asked what specifically should be sold, invariably, answers came back the same: “Sell everything!”

So how confident are you about what you hold in your investment accounts today? Would you watch your holdings fall in price as panic selling sets in among the crowd? Would you remain confident that, in time, prices would match your views on their future value?

Actually, I now find myself in much that same predicament. Because of my bearish views of domestic markets during the past couple years, I have either sold or reduced my stock exposure. So I am left with holdings that I refuse to sell, regardless of how many panic-stricken investors may sell them and what that will do to my holdings’ short-term prices.

Of course, I have already put in place defensive “hedges,” designed to mitigate market risk. Therefore, losses on the long side of my client portfolios will be offset, at least in part, by gains in my short positions. So I feel confident that I can hang on to the last of my long-side holdings.

After careful consideration, I remain firmly convinced that I will own these holdings at much higher prices in the long run. I am comfortable with these risks. And, given the size of my allocations in short positions and bear market mutual funds, those remaining long-side holdings act as my “hedge” against a rising market, short-lived as I think any rallies will be.

Regardless of what other investors do, I see no reason to part with my allocations in energy stocks or funds. I foresee nothing but higher energy prices in the longer term, with demand from rising economies like China, India, Eastern Europe and Latin America adding to our own wasteful consumption habits.

With central bankers around the world caving in to political pressures to add liquidity to the markets in the form of low-cost credit, I see no reason to sell any of my holdings in precious metals. For some odd reason, adding money and easy credit into an economic system like ours, which is reeling from previous easy credit availability and rapid money creation, seems stupid in the extreme. That they would add more of what got us into this mess in an effort to mitigate its effects amazes me. But since no central bankers will defend their currencies, I say “Load me up with precious metals!”

I also see no reason to dump my best foreign market holdings such as RIO, CRESY or PBR. They reside in economies that are not laboring under the strains of mindless, short-term economic policies like those in the U.S. or Australia, Spain or the U.K.

Countries like Brazil, Russia and Canada, now enjoying, budget and trade surpluses, will be the big winners when all current contagions settle out. So these are risks that I remain comfortable holding no matter how bad the domestic stock market becomes. Of course, holding large allocations in my selected “hedges” makes a big difference.

This is how one investor plays the game of risk. It is one example of managing a portfolio of risks. For too many others, investing is just another game to play. To me, it’s not a game, and managing risks is the primary job of portfolio managers in good times and bad. These times seem to be shifting rather dramatically from good to bad, so Looking at your portfolio as a basket of risks may be a good idea.

Have a great week.

Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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