You may have heard yesterday that JP Morgan has filed for a physical copper ETF, so it will hold metal in a vault as opposed to using futures to capture the exposure. If you look at any reasonably long term chart of copper you will see a lot of ups and downs in the price. Part of copper's volatility (or maybe all of it?) can be attributed to the extent to which copper is an indicator for economic health; you no doubt have heard some say that copper has a PHD in economics.
I am not one to buy into the idea that the bullion/physical ETFs are frauds holding nothing or holding less than they are supposed to hold in some sort of malfeasant situation. So in terms of removing any reasonable chance of a fund from JP Morgan failing, buying a physical copper ETF does not really become a risky endeavor it becomes a matter of altering the volatility characteristic of current holdings.
For most people I would imagine that buying a physical copper ETF would increase the volatility of the portfolio. There certainly is "risk" of losing money by holding this fund, should it ever list. Invariably people will buy at the high and copper is a commodity that is capable of falling a lot and whether a sale at a loss where to come from a panic sale or a sale based on a predetermined trigger point losing a lot of money is well within the expected probable outcomes. What is not well within the expected probable outcomes is the price of copper going to zero. Contrast this to a company that is grossly over levered operating in a segment with dramatically deteriorating fundamentals. In this case we are talking about true risk taking. The easiest examples to make this point could be Fannie Mae and Freddie Mac. Before the real crisis started there were warnings in the headlines about these companies (various restatements) and it did not take a background in forensic accounting to understand the gross overleverage--government guarantees notwithstanding.
Other examples of risk could be single-property resource companies where resources are believed to be but have not yet been proven or a single-drug biotech stock that has promise but nothing in the way of FDA approval. These types of stocks rely on a single outcome and are almost a zero sum game (depending on the finances a company with a failed outcome might be able to move on to another single outcome).
The above will cover the vast majority of potential portfolio holdings but there are other variables that might create risks that are not easily managed. One is political risk. Whatever the reality of the Yukos situation several years ago the net result is that the shares are gone and shareholders were essentially wiped out. There was some warning as news unfolded but Yukos unraveled very quickly.
People offer up similar concerns about China although I am not aware of a circumstance where China moved in on a company like that and investors ended up getting wiped out (apologies if I have that wrong).
So to the extent you do have volatility in your portfolio, that needs to be understood. To the extent you have risks in your portfolio it is crucial to understand the risks. Where both risk and volatility co-exist, a diversified portfolio should have some of each, it is important to understand how to mitigate adverse consequences that each can bring.
Where volatility is concerned I think the answer is to understand the current state of the market cycle. Taking a cue from John Hussman, do conditions favor the upside or the downside? If you believe the upside then volatility is probably your friend. If you believe the downside is favored then you should want to reduce the portfolio's volatility one way or another (selling stock, inverse funds, put options).
Where actual risk is concerned then paying attention to how various situations you own makes sense and does not have to be very difficult. One example of this I have referenced a few times over the years was Worldcom. In 1999 and 2000 there were several references to Bernie Ebbers have a $100 million margin loan against his holdings in the stock, I believe the symbol then was WCOM. I never owned that stock but the idea of the CEO have a margin loan at all let alone one that big made no sense to me. This sort of thing may not be a warning of going to zero but should be taken as a warning of something. Back to Yukos, regardless of who was right or wrong the management was ticking off the government. Maybe not a warning of going to zero but a warning of something.
This sort of thing is not the same a missing an earning estimate or giving bad guidance but are more along the lines of threats to the business which is a different kettle of fish. Holding a stock through a fundamental downturn is not the worst thing you can do as deathblow is not reasonably on the table. Understanding the differences should help avoid the real deathblows.
6 comments:
Thoughtful post, Roger, thank you.
From a behavioral standpoint, I find it more difficult to manage volatility than risk. The former requires some insight into the future--never easy--the correct picks to deal with the consequenses of that vision, and finally, the patience to wait for all of that to come to pass.
What do you look at to avoid the wcom and the enron's. Do not tell me you just look at the sales of stocks the direcextors.
Jeff From Milan, Italy
Debt on the balance sheet?
As someone who has learned much about stock/market evaulation on the internet, I can tell you that there are a LOT of people (experts, bloggers, etc.) who either associate risk and volatility or use volatility as a measure of risk for statistical purposes. It can get pretty confusing unless you just assume know one knows what they are talking about.
The reality is,though, that volatility does equal risk for most ordinary investors. I agree that it shouldn't, but it does.
READ HUSSMAN THIS WEEK
Post a Comment