{"id":2124543,"date":"2020-03-17T11:54:28","date_gmt":"2020-03-17T06:24:28","guid":{"rendered":"http:\/\/stockviz.biz\/index.php\/?p=2124543"},"modified":"2020-03-22T18:05:59","modified_gmt":"2020-03-22T12:35:59","slug":"risk-management-is-not-free","status":"publish","type":"post","link":"https:\/\/stockviz.biz\/index.php\/2020\/03\/17\/risk-management-is-not-free\/","title":{"rendered":"Risk Management is Not Free"},"content":{"rendered":"\n

Now that we are in the middle of a massive virus induced selloff, investors are once again interested in risk management. Similar to how flood insurance is mostly bought after<\/em> a flood, investors end up paying a hefty premium for fighting the last war. Our experience with offering strategies that try to manage downside risk has been that investors flock to it after<\/em> a drawdown, only to get disappointed by its returns once the market recovers and getting rid of it right before the next one. Rinse, Repeat.<\/p>\n\n\n\n

Risk management is not free<\/h3>\n\n\n\n

No matter how you hedge your risk (buying options, sell futures, trend-following,) it costs money. There is no system where risk management makes the investor money. So, by definition, hedged investment returns will trail buy-and-hold for long periods of time. <\/p>\n\n\n\n

Drawdowns and Returns are sides of the same coin<\/h3>\n\n\n\n

Equity risk premium exists because of tail-risk that cannot be modeled.<\/p>\n\n\n\n

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Nothing “normal” about it!<\/figcaption><\/figure>\n\n\n\n

No matter what your time-horizon, there are always periods when you will be deeply in a hole.<\/p>\n\n\n\n

Hedging instruments are not perpetual<\/h3>\n\n\n\n

Equities are perpetual but hedging instruments like futures and options have definite terms. They have their own peculiarities based on risk that is already being priced in vs. true tails.<\/p>\n\n\n\n

Simple Moving Averages can help<\/h3>\n\n\n\n

Being long an index only when it above an SMA is one way to overcome the problems highlighted above. It doesn’t involve hedging instruments, so you don’t have to worry about derivative pricing, expiry, etc. The odds are in your favor in terms of the trend being your friend. <\/p>\n\n\n\n

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On average, it pays to be long only when the NIFTY is above its 50-day SMA<\/figcaption><\/figure>\n\n\n\n

Most of the large daily moves occur when the index is below the SMA. Higher volatility is not necessarily bad if the drift is higher. But most investors rather sit out the volatility than dive in get their guts punched.<\/p>\n\n\n\n

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Next-day returns under different SMA “regimes”<\/figcaption><\/figure>\n\n\n\n

What would returns look like if you were long only when the index traded above its SMA? It really depends on your time horizon.<\/p>\n\n\n\n

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Including the 2008 GFC<\/figcaption><\/figure>\n\n\n\n
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Excluding 2008 and subsequent recovery<\/figcaption><\/figure>\n\n\n\n
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Annual returns<\/figcaption><\/figure>\n\n\n\n
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Get ready to be whip-lashed<\/figcaption><\/figure>\n\n\n\n
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Trade-off between lower volatility and higher costs\/gross returns.<\/figcaption><\/figure>\n\n\n\n

Problems<\/h3>\n\n\n\n