The Problems of Ruin, Near-Ruin, and Decay
Many investors, both institutional and individual, take too much risk. Taking too much risk can take a number of forms:
- Buying companies with weak balance sheets.
- Buying companies with high valuations.
- Inadequate diversification, whether by number of companies, number of industries, or some risk factor like buying only high-yielding stocks.
- And more…
There are three ways that problems can manifest themselves. The first way is ruin. An investor is so certain of himself that he uses a large amount of leverage to express his position. When the bet goes wrong, he loses it all; he is ruined. The second manifestation is near-ruin. As ruin is threatening, the investor sells everything to preserve some of his assets, often near the local bottom for that set of assets.
The third manifestation is decay. In this case the investor says, I will never take losses greater than x% of my position. Nice intention, but it raises the spectre of the death by a thousand cuts. Many assets fall before a significant rise; why get stopped out? Instead, use falls in price to re-evaluate positions, and consider adding if the original thesis is still valid.
To be a little more controversial here, I don’t trust the bold claims of most technicians who place stops on their positions, and claim to have good performance. Once one places stop orders, the probability rises for multiple small losses that exceed the few larger gains in the portfolio. Call me a skeptic, but I would rather re-evaluate my positions than automatically sell, which seems to me to be a recipe for decay.
November 1st, 20077:16 am at
David,
I agree. I use both mental stops, levels at which I reevaluate to see if my thesis is incorrect, and hard stops, stop orders that I have placed. I generally use hard stops for shorter term trades and for riskier stocks, and mental stops for stocks that I intend to hold for the longer term. It’s a hodgepodge, but flexibility can be valuable as you mentioned.
November 1st, 20078:59 am at
I mostly agree, and largely follow this in practice. However, to explain the technicians ideas a bit, I’ll point out the following principles:
1) they would advocate mental trailing stops or possibly conditional orders rather than actual stop orders;
2) often when an individual stock has fallen by X% their thesis on that individual stock has ipso facto not worked out;
3) the larger technical thesis is that the dynamic distribution of returns around certain chart setups is long tailed rather than Brownian, so they hope a good decision strategy with stops has an expected value exceeding market drift by some amount in excess of transaction cost, slippage, and excess taxation; clearly the validity of the idea depends on empirical details; if leverage amount is considered as a decision variable which changes with the setup, it makes things a little more interesting.
November 1st, 20079:13 am at
Nice results out of AIZ this morning and nice stock reaction, especially considering how the other insurance companies are doing today.
I think that there is some worry out there about the balance sheets of the insurance companies now that even the AAA paper is starting to appear to be risky. Based on what David has written here previously, that shouldn’t be much of an issue, so should be some good opportunities for portfolio upgrading through the end of the year.
November 1st, 20073:23 pm at
Re: Ambac/ABK
I’ve got no position, but listened to their multi-hour Q&A from their recent conference call (available on their website) and found their discussion of residential related risk controls and their overall financial health pretty convincing. That’s not to say that if Cramer et al. manage to convince their customers that they are going out of business because of losses that it can’t hurt their business enough to become self fulfilling.
November 1st, 20074:15 pm at
I don’t think CRamer’s views matter to the business; but certainly the stock can be affected. The bottomline is if there is not enough equity on the balance sheet in addition to the reserves for losses their existence is in jeopardy. Since no one can provide a mortgage by mortgage assessment of risk of foreclosure; and now risk models are suspect, the companies (if they make it) will probably have to issue equity to survive as few will want to lend to these poeple.
November 1st, 20074:38 pm at
Paul in K.C., if Ambac’s credit becomes perceived as no good then that will affect their ability to generate new business. But so far their actual operating earnings are not showing losses. Of course they could show losses in the future. One way to interpret events is that the mark to market losses on credit derivatives (by ABK and other bond insurers) mean that “the market” is predicting a future loss that will show up in operating earnings – the other way of intepreting it is that the market is driven also by fear, ignorance, and liquidity issues (e.g. MER can’t sell their CDOs so they buy a lot of swap to hedge, so the swap prices go up, and the bond insurers record a mark to market loss since they are essentially short these positions as a function of their business). But neither interpretation implies a prediction of continuing losses. Even if you believed that the credit default market for CDOs was priced perfectly to rational expected losses, that would be the present value of those losses for the life of the obligation.
November 1st, 200710:39 pm at
I agree with your points and i appreciate your explanations; I think the issue in the markets is SHOULD these people be allowed to write new business. From a business angle I agree that a poor view of the companies in this business makes going for an AMBAC guarentee not worth very much to the purchasers of the CDO product. I think would be a great itme for David to revisit his dericative blogs/articles. Do all the parties in these contracts have the (unleveraged) equity required to settle up. Great posts Gentleman
November 1st, 200711:03 pm at
Well if no one else is going to admit it, I guess I will: guilty 2 out of 3. Ruin once attacks one’s psyche making for near-ruin twice or three times. Its tough stuff to shake off.