One way to control risk is to identify “asymmetric” risk-return scenarios – 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 use to manage risk, the first step is to identify these asymmetric scenarios. This can be the key to avoiding big mistakes or capitalizing on big opportunities – and many times, both.
Consider the investment bubbles of the past dozen years: dot-com stocks, telecom, housing. In each, many investors accepted an asymmetric risk-return scenario, hoping 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 greater.
This kind of analysis is something high-net-worth individuals tend to do very well. Most have a knack for taking profits off the table before a bubble forms (or shorting assets after it does). And they generally have a keen eye for bargains, buying unloved assets with big potential before the crowd starts bidding up the price.
How do they do it? First, they identify asymmetric scenarios through research and analysis. After that, it’s a matter 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 second (and third) opinions and identify situations in which a market or asset looks to be getting over or undervalued.
Here are two recent examples.
Japan: Early in the year, we invited three well-respected investment managers to speak about international opportunities; 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 both downside and upside were limited.
The tsunami/nuclear disaster changed things. Suddenly there was a catastrophic (though temporary) disruption to the Japanese economy, which created a catalyst for 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.
U.S. dollar: Over the past 18 to 24 months, the Canadian dollar has strengthened against the U.S. dollar. Over the medium to long term, this is not necessarily good news.
A strong loonie may have a negative impact on our export-centric economy. And once the U.S. cleans up its budget problems, that should provide a catalyst for the greenback to strengthen.
Our analysis suggests the loonie could rise to its all-time highs (another US$0.05 to US$0.07) 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 US$0.93 to US$0.95. This is the very definition of an asymmetric risk-return scenario: $0.05 potential upside, $0.10 potential downside.
As a result, we’ve started to transition out of Canadian-dollar-denominated assets and into U.S.-denominated assets, encouraging clients 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 the trade perfectly. But when it comes to managing risk, we’d rather be generally right than precisely wrong.