There are many ways to make money in the financial markets.
No matter the investment philosophy and strategy, getting risk management right is crucial if investors want to survive for the long haul. What better way to find out more about the subject than from a veteran practitioner.
There are thousands of podcasts available for us to listen to, and this recent one from the Better System Trader with a veteran of the investment industry is a treasure.
Aaron Brown has a wealth of experience spanning various roles across institutions such as JP Morgan, Morgan Stanley as well as investment firm AQR Capital. In this podcast with Better System Trader, Brown shared some interesting insights on risk management.
Take the time to listen to it.
But if you do not have the time to, here are some of my notes to the podcast:
- The biggest misconception people have is that the purpose of risk management is to predict or prevent disaster – “We can’t do that. You want to make sure everyone understands the risks and its consequences.” It is about understanding the possibilities of your decisions.
- How does one go about identifying hidden risks that can’t be measured? Brown says liquidity risks are something to be aware of, and matters more for strategies with higher levels of turnover or those that need various kind of asset exposures. Additionally, it is vital to perform scenario analysis during the investment process, as well as stress-testing various assumptions.
- How should one approach drawdown management? When unexpected developments cause a drawdown and forces one to rethink his/her thesis on a position, Brown says it’s better to get out first and re-enter again when what you initially didn’t understand is over. “Once you know the level of which you didn’t understand the trade completely, you’ll know how much you could afford to lose and size the trade appropriately.”
- Regarding systematic strategies, Brown says it’s easier because of how the management is built into the whole system. It’s also vital to back-test it under various scenarios with as big a sample size of data as possible. Brown says that he’s a firm believer of quantitative drawdown control strategies that have been simulated to see how they have done.
- Brown stressed that the purpose of good risk management is not just to reduce or mitigate losses but also to provide the confidence to hold big risky positions when one can afford to.
- Creating a portfolio based of diversified strategies and investments is not necessarily ‘risk management’ as there are a ton of possible ways and varying exposures by doing so. Brown stressed that risk management isn’t about constructing the best portfolio at any point of time, it’s about “figuring out the best size to hold something given that you have decided on X”.
- Brown says that correlations are ‘mythical’. “There are thousands of factors out there… the huge ones are always moving markets and the rest are usually dormant, but each factor has a different correlation structure with all financial assets. So when we get a huge move in the market, it’s usually not because interest rates suddenly becomes twice as volatile, it’s usually because of some dormant factor suddenly rises up and becomes influential… when it happens you can’t rely on historical correlations because of these unexpected dormant factors suddenly driving market prices”
- Understand cointegration of asset prices when building a portfolio
At the end of the podcast, Brown also shared some of his thoughts on the current market environment as well as on cryptocurrencies…
Catch the podcast here!
Brown also has a personal website where he shares his thoughts on risk and on the investment industry.
Kean Chan 