How can I control risk in my portfolio? It's an important question for all investors of all levels of wealth. One way to answer it is to identify "asymmetric" risk-return scenarios -investment situations in which the possibility of loss is greater than the possibility of return (or vice-versa), or the amount of possible loss is greater than the amount of possible return (or vice-versa).
Whatever strategies you employ to manage risk (hedging, diversifying, dollar-cost averaging, etc.) the first and most important step is to learn how to identify these asymmetric scenarios. Depending on your goals, this can be the key to avoiding big mistakes, or capitalizing on big opportunities. And many times, both.
This isn't as difficult as it may sound. Consider the investment bubbles of the past dozen years: dot-com stocks, telecom, housing.
It's easy to criticize such investments in hindsight, yet the fact remains that, in each bubble, many investors accepted an asymmetric risk/return scenario: They hoped to capture an uncertain amount of further gain when any rational analysis would have concluded that both the possibility of loss and the amount of possible loss, were far, far greater than any potential gain.
In my experience, this kind of rational analysis is something successful high-net-worth individuals do very well. Most have a knack for taking profits off the table before a bubble forms (or shorting assets after it does). Nearly every wealthy individual I have met has a keen eye for bargains, for buying unloved assets with big potential before the crowd starts bidding up the price.
First, they identify asymmetric scenarios through research and analysis, by questioning market assumptions, by seeking out independent opinions, etc. After that, it's a matter of emotional control - of ignoring both the greed and the fear that can grip all investors (including the wealthy) from time to time.
Is such skill exclusive to the wealthy? Of course not. Today, any reasonably knowledgeable investor can perform some simple financial analysis, gather opinions (from advisers, analyst reports, the investment press, blogs, etc.), and identify several situations in which a market or asset looks to be getting overheated or undervalued.
Allow me to outline two recent examples:
Early in the year, we invited three well-respected investment managers to speak about international opportunities; Japan consistently came up as a subject of interest. All agreed that Japanese equities had been out of favour for so long there was little downside left. However, none of them could identify a catalyst for Japan. Risk and reward were roughly balanced, and downside and upside were limited. So we decided to look for opportunities elsewhere.
The tsunami and subsequent nuclear disaster changed things. Suddenly there was a catastrophic (though temporary) disruption to the Japanese economy, which created a catalyst for reconstruction and economic renewal. Over the longer term, Japanese companies would be the benefactors of that renewal. Risk and reward became asymmetric, and potential upside was greater than potential downside.
We began adding positions in select Japanese blue-chip equities for some of our more sophisticated, more opportunistic clients. We see this not as speculation, but a deep-value, contrarian investment that should add some alpha to clients' overall portfolios.
Over the past 18 to 24 months, the Canadian dollar has strengthened against the greenback, largely because of our superior fiscal situation. Over the medium to long term, this is not necessarily good news. A strong loonie may well have a negative impact on our export-centric economy. And once the United States cleans up its budget problems, that should provide a catalyst for the U.S. dollar to strengthen.
Our analysis suggests the loonie could rise at least to its all-time highs (that is, another 5 to 7 cents U.S.) in the short term, but in two to three years, it will likely settle to parity or below. In fact, purchasing-power-parity suggests the intrinsic value of the Canadian dollar is around 93 to 95 cents in U.S. funds. This is the very definition of an asymmetric risk/return scenario: 5 cents potential upside, 10 cents potential downside.
As a result, we've started to transition out of Canadian-dollar-denominated assets and into U.S.-dollar-denominated assets, encouraging clients to use the strong Canadian dollar to take positions in U.S. equities and real estate. We haven't done it all at once, because there's no way to time such a trade perfectly. But when it comes to managing risk, we'd rather be generally right than precisely wrong.
Mr. Stenner is director, wealth management, and founder of Stenner Investment Partners of Richardson GMP. He is managing director for TIGER 21 Canada and author of True Wealth.