The Hindu Business Line : What ‘long-term’ portfolio? Risk management for the trader

Stock prices are down more 50 per cent down from the all-time highs. This sharp decline in prices has resulted in large losses for even the astute traders. Most “investors” continue their loss-making exposure under the pretext that asset prices would move up in the “long-term”.

This article carries a message for these “investors”. Specifically, the article shows that every “investor” is essentially a long-term as well as a short-term trader within the core-satellite portfolio framework. A trader should, hence, have a risk management system to ensure that the portfolio meets the horizon objectives.

Investor Vs Trader

A commonly-held belief is that an investor is a person with a long-term horizon whereas a trader is one with a short-term horizon. The real difference, however, has to do with the source of returns, not with the length of the investment horizon. A trader is a person who depends primarily on market prices for returns. An investor, on the other hand, depends on dividends.

The market primarily consists of traders because the sharp rise in asset prices since 2003 has made dividend yields largely irrelevant. Endowment trusts create portfolios only for dividend income. But such structures are a small proportion of total investments in the market.

Consider an individual who wants to structure a core-satellite portfolio to fund her child’s college education 5 years hence. The core portfolio will invest for a 5-year horizon while the satellite portfolio will trade actively to generate short-term income.

The horizon objective will be met only if the portfolio generates the desired returns. And that is largely dependent on the asset prices at the horizon as well as in short term. This dependence on market prices at all times necessitates an appropriate risk management system.

Risk tolerance Vs Loss tolerance

A systematically-structured portfolio would be based on the investment policy statement. This is a statement that lays down the investment objectives, risk tolerance levels, expected returns and other constraints of the trader.

Emotions play a significant role in the portfolio management process. “Investors” typically believe that stocks carry an upside bias in the long run. This pushes such “investors” to non-action when asset prices decline.

At the other extreme is the trader who is overly conscious of short-term losses. Often, such traders cut their exposure sooner because their loss tolerance level is lower than their risk tolerance level. Suppose the risk tolerance level is 10 per cent, there is a strong likelihood that the trader will sell her holdings if the portfolio declines 7-8 per cent. The reason is to do with the inability to hold on to the loss-making positions when asset prices decline.

Cutting exposure too soon as in the case of the short-term trader denies participation in further upside in asset prices. Carrying exposure for too long as in the case of the “investor”, however, exposes the portfolio to large downside risk. It is, hence, important to actively manage losses within the core-satellite framework.

Managing losses

It is easier to manage losses in the satellite (short-term) portfolio as such trades are set-up with strict stop-loss levels to manage the downside risk.

A different risk management approach has to be adopted to manage losses within the core portfolio. One approach would be to optimally size the exposure to minimize downside risk.

Suppose Tata Steel has a further downside of Rs 80. If the risk management system allows a downside risk of 2 per cent on a total capital of Rs 25 lakh, the capital-at-risk on Tata Steel will be Rs 50,000 (2 per cent of Rs 25 lakh). The core portfolio can take exposure to not more than 625 shares (Rs 50,000 divided by Rs 80 per share).

What if the portfolio has exposure to Tata Steel in both the core and the satellite portfolio and the stock declines by more than Rs 80? The trader can choose to do nothing with the core exposure but may take losses and cut exposure in the satellite portfolio.

This allocation of assets between the core and satellite portfolio and the different risk management rules reduce overall downside risk. Investor-traders can also “borrow” shares from the core portfolio and engage in some disciplined trading to reduce overall losses. Besides, once the long-dated options on Nifty become active, traders can buy insurance to protect downside risk on the core portfolio.

Conclusion

It is important to understand the difference between traders and investors. Appreciating the difference enables better management of portfolio risk. This article shows why “investors” should be concerned about the price levels through the investment horizon. It also suggests some risk management rules that traders can adopt to minimize downside risk within the core-satellite framework.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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