“You can take risk. Just don’t lose money.” – A Former Boss
Risk management seems like a simple endeavor. It’s not. It requires a deep understanding of what risk is and how it can be managed. Some think that simply being strong is the answer. It’s not. Many think of risk as something you deal with after the fact, and it shows in their pitch. “I will force positions to be shut down.” “I will step in and close positions myself.” “We will cut risk…” All of these statements reflect a reactive risk management process. While they sound tough and disciplined, they are really just impulsive behaviors attempting to clean up impulsive behaviors, after the damage has already been inflicted. Fact is, the biggest hedge fund disasters don’t occur when funds are doing poorly. They come about when they are doing well, and risk management has been sidelined. That’s why every loss and every gain attracts my interest in exactly the same way, for the most effective risk management is both proactive and consistent execution.
Risk Management Placebo
“Hard work pays off in the future. Laziness pays off now.” – Steven Wright
Donuts. Heroine. Drunk driving. Unprotected sex. Speed bumps. For those who choose to partake, they all offer immediate gratification, but at a tremendous cost over time. There is a wide divide between what feels good to you and what is good for you. I choose to abstain from all of the above. I assume the first four in my list are self-explanatory, so I will concentrate on the fifth — Speed Bumps.
The speed bump is a generally accepted risk management tool. Essentially it serves as a line in the sand which triggers a specific reaction. As an example, if a portfolio manager is down 5% from the high water mark (HWM; peak profit), then her risk is halved. If it happens again, risk is halved again, and so on. It’s one of those things that sounds good in a marketing presentation, allowing a fund manager to masquerade as a disciplined risk manager. The problem is that its mere existence creates an impediment to thinking deeper about and implementing more effective, proactive risk management procedures. Worse yet, speed bumps ultimately serve two distinct purposes. They reduce the returns of a good investment manager and they extend the life of a poor one. The better the manager, the more dramatic the negative impact, and vice-versa.