During the heady days of 2013, I published a piece called the Ten Commandments of Risk Management.  As always, it was meant to entertain along with enlighten.  Now, five years later, I am putting the piece out in slightly modified and enhanced form.  I hope you don’t think this makes me a bad person.  If I remember correctly, after all, Moses himself received the tablets from God – not once but twice, so perhaps my readers will grant me a similar mulligan.

Much has changed since the original publication of this document, but more remains the same.  Most of The Commandments, are in fact, timeless.  But context, always context, changes with the very cells in our bodies.  So I think it’s time to take another look.

The Ten 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 purpose 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 meet challenges with complexity versus simplicity, derive nuanced solutions, and, when this works, to pat our own backs in wonderment at the clever people we are.

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 in a familiar form – The 10 Commandments – which, if you follow them, will give you a sustained 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, read as mostly blindingly simple rules of common sense.  Yet even the most sophisticated portfolio managers routinely abuse 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 that of 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, you are 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.

It’s best then to determine exactly what drives your own market participation, and setting objectives accordingly.  If trading is more than an avocation, and occupies significant portions of your time, then managing how you use this time is a tool to address one of the most binding constraints to performance 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.  Whichever category you call home, 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, you’re working for some institution, and, while you can clearly identify a personal goal of making the highest return 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 at hand to be at your best while navigating these markets.  Even for less active investors, a similar path is recommended.  You should, for your own benefit, determine what markets you will focus on – based upon what advice and information – and how much personal attention is required.

Virtually all investors 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.

I’d like nothing better than to discuss this with you privately (it is, after all, a highly personal matter), so if the spirit moves, shout me a holler.

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, it 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 performing 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.  Heck, it’s hard enough to succeed even when you are rigidly sticking to your approach.

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’ve 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 fabulous 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 stakes 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, but 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 you are taking noticeable pain on individual positions, others will provide some relative comfort, and even more so if you add hedges or long/short balance to the mix.

In any event, there are tools available that enable all of you 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 positively sail on the somnolent, forgiving market seas of 2017, in February of ’18, the becalmed waters began to churn angrily.

If you held a static portfolio and didn’t do a single trade since the vol picked up, then it is likely that your volatility doubled, tripled or more — relative again to ’17.

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 ten.  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 prerequisite 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 third 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.

I have some simple formulas we can share with you that will provide you with an adherence roadmap for Commandment VII.  In the meantime, I will conclude thoughts on the seventh 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 or selling short 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 themes 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.  Call it blasphemy if you will; I call it common sense.  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 sacrilege 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.

Commandment X:  Obey the 10 Commandments 

I feel compelled to inform you that in the revised set of tablets, I was sorely tempted to move Number 10 up to Number 1.  One way or another, I think that adherence to the actual laws handed down from on high, are for our unilateral benefit. They represent the core precepts of righteous human behavior, and in the 3,500 years since their original, well, publication, no one, to the best of my knowledge, has ever even legitimately questioned them.  While observing 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.

In these troubled times, I can’t emphasize how strongly I feel about #10.  So stop lying, stealing, committing adultery, coveting your neighbor’s wife and taking the Lord’s Name in vain.  Some good will come of this, I promise you.

There’s a lot more to be said about all of the above, but we can only do so much with the written word, right?  If the spirit moves, contact me and we’ll talk.

Trust me my brothers and sisters, it’ll do you no harm.

TIMSHEL