Risk Management: It's All About Discipline

Jun 23 2006 | 9:13pm ET

By Mark Smith, Guest Columnist  

Oh how times have changed! Markets down, volatility up, dollar down, interest rates up, gold down (well, this week anyway). A lot going on in the world with terrorists, wars, nuclear threats, oil threats and options being back dated…gh! Many years ago some smart person said, "With adversity comes opportunity." Right, they never had to trade these markets! That's why God created shrinks, single-malt scotch and risk managers to help us through these trying times.

As of this writing, the NASDAQ is down 1% from its May high with very little support from increasing interest rates, inverting yield curves and lack of sector leadership. Times like these will occur over and over in your career, as they have in my 14 years in this industry as a risk manager. There are opportunities, though they are more difficult to find, and it is not impossible to survive. I have worked with, and for, some of The Street's best traders, providing them with risk management information and insight on their portfolios. One thing that I found existed in the best traders and lacked blatantly with the mediocre ones was discipline.

Trading and investing in the markets is a sport that ebbs and flows with manifold and mind-boggling variables; which we rarely can fathom in their entirety. So, we try to grab a small piece and understand it the best way we can while still trying to make money. The great traders have the uncommon ability to manage their portfolio with discipline consistently throughout both easy and rough times with smaller draw downs and above average gains.

When I started in this industry in 1991 as a trading assistant, there was much less competition for investors' capital then there is now. Today, you have to show the institutions, the family offices and the funds-of-funds that you can carve out alpha better and more often than the next guy, all while keeping your volatility acceptable.

Discipline keeps you on course to be successful.

Discipline keeps you from trading out of your element.

Discipline keeps you from overtrading and underachieving.

Discipline keeps you from buying that new healthcare IPO that you know will make 25%, when you are known as a technology specialist.

You might be reading this wondering "what the hell is this guy talking about and how does it relate to risk management?" Well, we risk managers, along with your investors, appreciate a portfolio manager who we know will follow his or her strategy consistently and effectively during the various economic and trading cycles. As a risk manager, I need to know that you have the discipline not to let your pride get in the way you manage your portfolio. You need to keep your position exposures within established risk parameters and exit your losing trades while they are still just a small nuisance. Risk management is far more than just calculating Value-at-Risk (VaR) and telling you to get out of a position. That is part of it, but it is also knowing your strategy and how you tick, especially during major market events.

These past few weeks the "worldly wisdom" of the Fed has created a volatile market. This is a traders' market, not an investors' market. A disciplined trader would not fall in love with his positions, would manage smaller position losses and would wait for "his" market to show up. The disciplined trader would review his portfolio's leverage intra-day and at the end-of-day to ensure that he is not over extending his capital. He would review the number of trades he makes each day to see if he is over- or under-trading his positions and why. He would use metrics like VAR and stress-testing models to see if his portfolio's risk is more or less relative to his gross exposure. These prudent risk management steps will help you manage greater profits and keep you in the game another day.

In these times of great, albeit fleeting, opportunities it is your responsibility as a portfolio manager to do-no-harm, protect your capital and continuously look for alpha. Review your risk management practices, metrics and procedures manual because they will provide a roadmap for better risk management and oversight of your portfolio. However, all the risk systems, risk data, and risk procedures are useless unless you have the discipline to utilize them effectively.

Mark Smith is founder of Mark Edward Advisors, LLC. A Risk Management Service that provides daily independent Risk Management reporting and analysis to the alternative investment industry. Mark has developed risk systems and has been a senior risk manager for SAC Capital Advisors, Chang Crowell Mgr., and Parker Global Strategies.


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