The Dude Abides and So Should You: “The 10 Commandments of Risk Management”, Guest Post by Ken Grant

by Ken March 29, 2013 1:14 pm • Commentary

I would like to introduce a great friend and former colleague, Ken Grant as a contributor to  Ken and I worked together at SAC Capital back in the late 1990s and at Exis Capital in the early part of last decade, where he served as Head of Risk Management at both firms. Additionally Ken ran risk at the fine hedge fund firms Tudor Investments and Cheyne Capital, before starting his own outsourced risk advisory firm Risk Resources in 2005.  Ken is also the author of Trading Risk: Enhanced Profitability through Risk Controla book that I have read on more than a few occasions.  We welcome Ken and his frequent insight to and we look forward to sharing his views on the markets and risk management with our readers.  Follow Ken on Twitter @kengrantriskmaven

For the benefit of our readers, Ken has synthesized his main risk management tenets below, and I implore all of your to read it and attempt to incorporate any or all of his advice into your trading/investing, your PnL will thank you for it!


The 10 Commandments of Risk Management 

The subject of risk management, while increasingly topical in the modern financial universe, is often abused through over-analysis, over-complication and hubris among purported experts.  As a longtime risk manager, I think the Number One goal of risk management, as a professional discipline, is to take complex, content-rich concepts such as transactions and portfolios, and simplify them down for the purposes of making clear-headed decisions.  Do I want to do this trade or not? Am I comfortable with the amount of money I could lose in my current portfolio, based upon available information? What changes can I make if I’m not comfortable?

These are the questions that “true” risk management seeks to answer, but too often, these simple objectives are obscured by the very human tendency to over-complicate issues, derive nuanced solutions, and show mental superiority to the world at large.

Do you want to be the smartest guy in the room or the richest?  Most would choose the second option, and, while risk management can be of enormous assistance in achieving this objective, it is only one tool in the trading/portfolio management arsenal, and the simpler it is to use the better.

Trends towards simplification of objectives and ease of interpretation are beginning to work their way into the murky field of risk management, and the purpose of this piece is to provide you with some basic guidelines – the 10 Commandments – which, if you follow them, will give you an enormous edge over many market participants who routinely violate them.

It may or may not surprise you to learn that my 10 commandments, like the ones that came down from the biblical Mount Sinai, are mostly blindingly simple rules of common sense.  It is a constant wonderment to me that they need to be articulated at all, but – trust me on this one – even the most sophisticated portfolio managers routinely violate them.  However, this is also true of Moses’ tablets, as, even the most righteous among us will occasionally lie, covet our neighbor’s wife, or fail to honor our fathers and mothers.

So I offer the following set of simple rules, with the forewarning that, like biblical teachings, the enumerating of them is a much easier task than living by them.


Commandment I:  Establish/Understand Market Participation Objectives.

In terms of sound risk management, forming a clear understanding of the forces driving your market participation is as good a place as any to start.  After all, if you don’t know why you’re trading or investing, your placing extra burdens on yourself in terms of the already-difficult-enough-as-it-is challenge of actually making money in the markets.  Some of you are professional investors; other participants are in this game for more personal reasons.

Let’s start with this latter, more diverse group.  If you’re not paid professionally for your toil and sweat with research reports, lazy, know-nothing brokers and flashing screens, you should take a moment to determine what you’re hoping to accomplish by being in the markets at all.  Here, the answers might run the gamut – from very active market participants who actually trade their own capital for perpetual income generation, to those who dabble occasionally and hope for the best, to those who own stocks, bonds and commodities simply because they believe they are critical tools for wealth preservation and enhancement.

So best place to begin is by determining exactly what drives your market participation, and then setting objectives accordingly.  If trading is more than an avocation, and occupies significant portions of your time, then how you use this time becomes the most binding constraint to success.  Alternatively, if you are a routine, occasional dabbler, then the constraints shift: from time, to market information and access to resources, and it behooves you to make sure these are best in class.  Finally, if you’re simply a passive investor, then your success is largely a function, at least on a relative basis, of the quality of your advisors.  However, whatever category into which you fall, it is certainly in your interest to have identified it, as this will drive many actions and choices set forth in the remaining 9 commandments.

If you are a professional investor, a similar, but far from identical, exercise is in order.  Presumably, your working for some institution, and while you can clearly identify a personal goal of making as much money as possible in the shortest period of time, and getting paid as much as possible, these objectives may not align with precision to those of the organization for which you work.

So it is absolutely in your interest to understand the investment mission of your employer.  But go deeper than that.  Understand how it gets paid, how it achieves growth and enterprise value, and this, in turn, may require a look-through to the types of clients that fund your institution, and an associated understanding of their investment goals and objectives.  You’d think these things are obvious, but in my experience, many market participants, both professional and amateur, fail to undertake this simple exercise, and, without doing so, almost certainly set themselves up for failure, or, at minimum, sub-optimal success.

As a last point regarding this new-age self-analysis, for both professional and personal investors, the objectives of the investment process may change over time, so my further advice is to go through this exercise, at minimum, once every couple of years.


Commandment II:  Establish an Investment Approach that is Consistent with Commandment I Outcomes.

Once you’ve determined where you fit into the market mosaic, you can and should make a detailed study of the various roadmaps to success.  For full-time traders (professional or personal) this involves determining what markets in which you wish to participate, and what resources you need to be at your best while navigating these markets.  For less active investors, a similar path is recommended.  You should, for your own benefit, determine what markets you will focus upon, based upon what advice and information, and with how much personal attention is required.

Investors of every stripe should establish look-back methodologies for measuring their relative success, on a routine, periodic basis, with an eye towards understanding clearly what they did well, where they under-performed, and what steps they can take to learn from past experience, and achieve improvement in future cycles.  We can tell you how to do this, but first you have to ask.


Commandment III:  Establish Financial Objectives and Constraints.

No matter what your market orientation, you are likely constrained, in gravity-like fashion, by one unshakeable reality: there is a finite amount of money that you are able to lose and still remain in the game.  This will vary by the type of market participant you are or wish to be (in adherence with Commandment I), but even within any given participant class, will shift and evolve along with market conditions, performance, the sources of your funding and other factors.

So it behooves every market participant to determine, periodically, how much money they can comfortably lose, and in order to do so rationally, this impels them to set return targets as well.  Except under very narrow circumstances, no clear-thinking market participant would set a maximum loss level, at, say, 25% if his or her target return was in the low single digits.  So, entering every period (and for many, most importantly at the beginning of each year), effective portfolio management implies a comprehensive analysis of the range of likely outcomes, which yields the simple, declarative outcome of identifying with clarity the variables in the following statement: “My objective is to generate a return of X, and am willing to lose up to Y to achieve this goal”.

The most visible objectives of this exercise are to create focused parameters for success and failure, but there are indirect benefits to be gained as well.  In my experience, it is impossible to derive an honestly formed estimate for X and/or Y without undertaking an analysis of general concepts such as market conditions and resources at your disposal, down to more granular details of what instruments you intend to trade/invest in, and why.  Trust me: you only stand to benefit from routinely undertaking this exercise, and, at various points, looking in the rearview mirror to see what went right, what went wrong, and why this was the case.

For professional investors, these “mission critical” parameters may be set by your capital providers and not by you personally, but sorry, Mr. Wall Street, this doesn’t let you off the hook; if anything, it places extra burdens on you with respect to Commandment III.  In a highly constructive work environment, you will have a say in these matters, and even if your return budget and loss limit is set at levels with which you fail to agree, you’ll be doing yourself a world of good by making your arguments on an informed basis.

Perhaps, if proven right with enough consistency, your bosses may eventually start listening to you, or you will find a professional home wise enough to take your input into their decision-making process.


Commandment IV:  Stick to Your Methodology.

These commandments, at least the ones set forth thus far, are sequential and path-dependent in nature, and if you follow the course, by now you’ve figured out why you’re in the markets, developed a methodology consistent with this first commandment, and have parameterized your return objectives and maximum loss thresholds.  It’s now time to go get them out there, and it will serve you in good stead to operate by the precepts of Commandment II.  You may be a superstar at your investment approach, or you may simply be a legend in your own mind.  But one thing I’ve learned from experience is as follows: if you deviate substantially from your methodological disciplines, you stand almost no chance of succeeding in the markets.

This means keeping to a list of tradeable instruments with which you are comfortable, knowing the ranges of your investment sizes and holding periods, and, ideally, both having tools and self-awareness to know when you have gotten it wrong, as well as the discipline to act upon mistake identification – ideally by wiping the slate clean and starting over again.

If this happens, and you find yourself compelled to retrench, I implore, nay command you to stick to your knitting.  For the personal investors among you this means resisting the temptation to rush into some hot stock tip you heard about at the country club bar, or a complex structure that your broker/advisor is very keen to stick in your portfolio.  These transactions are indeed money-makers, but for others (e.g. your broker/advisor); not you.

The same dynamic applies to you blinged out pros.  Sell-side folks of every stripe will try to sell you on clever angles that seldom, in my experience, provide benefit to those to whom they are pitched.  So if you crawl down the rabbit hole, start climbing, and use the path of your descent, as it is the clearest way back towards high ground.


Commandment V:  Understand the Profitability Dynamics of Your Portfolio. 

The sum total of your trading and investing activities create something we risk geniuses refer to as a portfolio.  It contains, in most cases, a mix of financial instruments, and, in some instances, may include short bets and derivatives.

It is worth your while to understand what drives this aggregation of your market activity: what conditions will cause it to make money and what dynamics will be either dilutive to returns, or generate outright losses.  For both pros and amateurs, it behooves you to review these hypotheses with routine frequency.  A word, here, to most of the personal investors and a few of the professional ones as well: many of you have multiple accounts, often held at different financial institutions.  But your financial fortunes are tied to what happens to the totality of your holdings, so, in order to adhere to the 5th Commandment, it may be necessary to find a way to aggregate your holdings across investment accounts, possibly held at multiple financial institutions.

We are now half-way through the entire exercise, and can move from the left tablet to the right one.  Nothing too painful has happened to us yet, right? But fair warning, we’re about to enter the murkier ground where risk analytics cannot be entirely avoided.  I am confident, though that you can handle this.


Commandment VI:  Understand the Volatility Dynamics of Your Portfolio.

Each individual financial instrument that you own has its own unique volatility characteristics, which, to further cloud matters, will change over time and market conditions.  Your favorite Canadian Oil Exploration company or Bio-Tech concern is more volatile, and therefore, all things being equal, riskier, than, say, your money market holdings or your dividend yielding holdings in, say, Consolidated Edison.  You should understand these dynamics, using such tools as Beta and volatility (the standard deviation of returns).

Of course, the volatility of your portfolio will not be equal to the sum of its individual risks, and here I have good news: the portfolio as a whole will almost certainly be less risky than the sum of its parts – due to the impacts of diversification.  Individual instruments will not likely move in lock step with one another for extended periods, and this means that under most circumstances, when your taking noticeable pain on individual positions, others will provide some relative comfort, even more so if you add hedges or long/short balance to the mix.

In any event, there are tools available that enable investors of every stripe to measure the volatility of their portfolios as though they were single, individual instruments.  These are extremely useful – particularly in today’s environment, under which external events can change volatility profiles dramatically, and without notice.  To provide one recent example, after a relatively benign and bullish first half of 2011, market risks increased abruptly in the 3rd Quarter – largely due to the mismanaged Washingtonian debt ceiling debate, and the subsequent downgrade of U.S. bonds by S&P.  If you held a static portfolio and didn’t do a single trade across the entire year, then it is likely that your volatility doubled, tripled or more — from the 2nd to the 3rd Quarter.  As a result, a portfolio you may very well felt was stable carried significantly greater risks at certain points relative to others.

These trends of instability of risk across market cycles are likely to continue well into the future, so, in order to manage in a clinical manner, the risks you are assuming, it is necessary to understand over dynamic investment cycles, the overall market risk profile, and its incremental impacts on your portfolio.


Commandment VII:  You Are Able to Risk More When You’re up than When You’re Down.

Though buried in the middle of the second tablet, Commandment VII is as important a rule as exists of the 10.  If you’re p/l is positive and rising, you are essentially playing with house money, and can take risks that are not wise to assume when the opposite condition exists.  However, I hasten to add that these concepts are asymmetric in nature.  Just because you happen to be making money doesn’t mean you should increase your risk-taking; being up is thus a necessary but not sufficient condition for opening up the throttle.  The other pre-requisite is that you like the forward-looking opportunities you see on the horizon.  If you don’t. then either stand pat or take chips off the table, as no rational risk-taker should increase his or her bets if they don’t like the forward-looking feel of the markets.

Conversely, if you’re losing money, your viewpoints on the market become largely irrelevant to us risk managers, and we will encourage you to remove risks from your portfolio no matter how much money this may cost you in terms of future returns.  Here, we revert back to the 3rd Commandment: the one where I have instructed you to set a maximum aggregate loss for your trading and investment.  The closer you get to this stop-out level, the less firepower you have, and, if you want to stay in the game, it really doesn’t matter how much you like the markets.  After a bad spell, you should reduce risk.  If you’re proactive about this, you can still nail your best ideas – albeit in smaller sizes.  But if you do the opposite – double down, and subsequently happen to be wrong, I suspect we won’t have much to talk about in the future.  The professionals among you may be looking for new lines of work, while personal investors might be too occupied with mundane matters such as how to pay the mortgage to devote much time to the markets.

We have simple formulas we can share with you that will provide you with an adherence roadmap for Commandment VII.  In the meantime, I will conclude my thoughts on this topic with the following truism: the risk more when you’re up/less when you’re down thing works in all endeavors of chance.  It’ll perform just as well in Las Vegas as it does on Wall Street.  Trust me on this one.


Commandment VIII:  Set Targets for All Individual Positions/Themes and Stick to Them.

Before buying a stock, bond or option, you should determine the price which you seek to achieve, the one on the negative side that will cause you to admit the folly of your ways and exit the position, and some idea of the timeframe over which you intend to hold these positions.  Keep a spreadsheet of these Objectives, Stops and Dates and update them frequently.  It will also do you a world of good to keep a close eye on positions that have reached or exceeded your positive and negative targets.  Here, you have two choices: either change your target, or exit the position.  There’s simply no reason to hang around in positions that have already played out, positively or negatively, according to your expectations.

Adhering to Commandment Eight may cause you, fair warning, to deviate from the long-standing, but in my view fallacious risk management platitude that you should sell your losers and let your winners ride.  More often than not, and particularly if you truly have an “edge” in your area of market focus, your risk reducing activities should more productively be shaded towards getting out of positions that have already done their work for you, while holding on to losers that, if you’re right, will pay off in spades.

The best means of achieving risk reduction on a name-by-name basis, in my view, is to go through what I call the “Vince Lombardi/Gentlemen, this is a football” exercise.  Review each individual position, and forget whether they’ve made or lost you money in recent innings.  Pick the positions that you believe offer the best value at current prices, and discard the rest.

Empirically speaking, I promise you that this process will lead you to shed more of your winners than your losers.


Commandment IX:  Fear Not Options, Including Their Short Sale. 

Without getting into great detail, changing market conditions wreak havoc on options pricing, and these markets often give away some of the best opportunities you’re ever likely to see.  Moreover, if you buy into this, combined options positions, including bull spreads, bear spreads, straddles, strangles and butterflies, can, if properly timed, be had for a song.  I also believe strongly, particularly in high-volatility markets, in using covered write strategies, as a means of reducing exposure to individual names, and for yield enhancement purposes.

To further express risk management blasphemy in this otherwise holy document, I believe that those who believe that selling options is riskier than buying them are deeply misinformed.  Empirical evidence suggests that well over 90% of options expire worthless, so who’s making money/taking more risk: the buyers or the sellers? This is not to say that I countenance the unconstrained selling of premium; quite to the contrary.  My main philosophy with options is to seek to apply the basic strategy of buy low/sell high to this instrument class.  If options are cheap, buy them.  If they are expensive, sell them.  Quite often, you can find both conditions within the framework of an individual underlier, and, if you do, you can benefit from arbitrage opportunities that much of the market seems to routinely ignore.

On this interesting and complex topic, I now defer to the folks at RiskReversal, who are experts in the field, and who can guide you towards options strategies with positively skewed payoff functions, in a market universe, which, in my judgment, trades options with a distinct lack of wisdom.


Commandment X:  Obey the 10 Commandments 

Here, I speak to the ones they teach you about in your religious studies; not those contained in this document.  They represent the core precepts of God’s Law, and Man’s as well, and, while adhering to them with perfection is perhaps beyond the abilities of individual members of the human race, attempting to do so will do you a world of good, including in terms of portfolio returns.  Remember: our universe was created by the Lord, while markets are entirely the creation of Man.  When we seemingly needed it the most, he gave us the Law, as embodied in the Commandments.  Following them just might give you, divinely speaking, a little extra edge.

Similarly, following the Golden Rule will also do neither you, nor your portfolio, any harm.

There is of course much more to say about risk management than can be held by two stone tablets that I personally was compelled to carry down from the mountaintop.  Like those of the Old Testament, my rules will be followed imperfectly, but do your best if you can, and I think you’ll get better results.

Yes, there’s more to say about all of this, but start with these, and we’ll push into greater detail, later.


Peace Out.

Ken Grant