A real RocknRolla in the investment business

A real RocknRolla in the investment business

People ask the question... what's a RocknRolla? And I tell 'em - it's not about drums, drugs, and 

hospital drips, oh no. There's more there than that, my friend. We all like a bit of the good life - some

the money, some the drugs, other the sex game, the glamour, or the fame. But a RocknRolla, oh, he's

different. Why? Because a real RocknRolla wants the fucking lot.

In my opinion, there exists a similar rule in the investment business. A real RocknRolla in the

investment business wants to get compensated for the risk he assumed. Thus, he always speaks in

terms of risk/return when referring to the performance of his investment portfolio.

A very powerful tool for that purpose is the so called risk allocation. Doing a risk allocation means to

indentify ex-post and ex-ante the risk contribution of each portfolio position to the overall portfolio

risk.

Many asset management companies do the mistake and concentrate mainly on the return side of the

equation. However, if there is no free lunch, which is nearly always the case, there is also no

investment return without initially presumed risk. Thus, we need to make sure that we just take on

risks which have a high enough probability of rewarding us sufficiently.

Hence, ex-ante, the risk allocation provides an overview of where the risk lurks. Ex-post, it shows

where the risk came from. Having this insight, we can manage the overall portfolio risk more

efficiently.

Here is an example of how an ex-ante risk allocation could look like:

Assets expected Volatility Asset Allocation Marginal Risk Risk Allocation

CH stocks 15.50% 60.0% 0.1438 8.63%

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83.8%

CH bonds 7.40% 7.7% 0.0278 0.21%

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2.0%

Non-CH bonds 11.10% 32.3% 0.0451 1.46%

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14.2%

Portfolio 10.30% 100.0% 10.30%

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100.0%According to this allocation the most portfolio risk clearly comes from CH stocks (83.8%). Therefore,

in this case it is essential to have a well reasoned expectation of sufficient future return (compensation)

for this bulk of risk.

Finally, knowing where the risk comes and came from, we also have to assess if the expected return

and effective return (compensation) is sufficient.

In my view, RAPM (risk-adjusted performance measure) is the most efficient methodology to measure

that. The formula is RAPM = Profit / RC (risk capital). The risk capital can be computed as a VAR

(value at risk;

http://en.wikipedia.org/wiki/Value_at_risk 

) measure at the 99% confidence level.

Assuming normal distributions, the RC = VAR = 2.33 x Volatility x Notional.

For example (ex-post), the UK stocks and UK bonds have a notional amount and volatility as

described in the table below. The notional amount is also the market value. The RC for UK stocks =

2.33 x 0.15 x £ 200’000 = £ 69’

Computing RAPM

Profit Notional Volatility VAR RAPM

UK stocks £ 20’000 £ 200’000 15% £ 69’900 29%

UK bonds £ 10’000 £ 200’000 7% £ 32’620 31%

Thus, although UK stocks returned £ 10’000 more than UK bonds, UK bonds have actually performed

better than the UK stocks, as they required less risk capital.

A real RocknRolla in the investment business always has a clear idea which and how much risk he

assumed.

I was recently asked where I think the global equity markets are heading and where I think the price

targets of the DAX and the DOW are.

I’d like to answer this question in terms of risk.

On the one hand, we’ve experienced a heavy consolidation in the stock market last week because of 

the problems in Europe (the Greek problem, the sustainability of the EUR) and special automatic

trading systems which accelerated the selloff. Generally, the market participants are very nervous and

this will keep the volatility high.

On the other hand, the monetary policies around the world tremendously boosted the liquidity out

there. It is highly probable that some of this money is waiting to be invested at lower prices. And as

soon as this cash pours into the stock market the recent upward trend would continue. Ps. as we have

seen today... (most stock market indices surged heavily today)

In some of my earlier Jeffrey Investment Letters I explained in detail why I’m sceptical and prefer

conservative investment strategies at the moment. The return I expect from stocks is just not high

enough to compensate for the expected risk. Nonetheless, for diversification reasons it is worthwhile

to possess some well chosen stocks or ETFs. Otherwise you would have completely missed the recent

stock market rally.

Having said that, I don’t know where exactly the markets are heading and I don’t know where the

price targets for the DAX and the DOW are. And I don’t need to. With some chart analysis one could

certainly find some possible support and resistance levels. However, knowing them wouldn’t make

you a better investor.

Far more important is the investment strategy you choose. The investment strategy is the critical point

which separates the money makers from the gamblers. Thus, given the risks I’m pointing to since the

beginning of the year, I would tackle the market with strategies like my special version of the CPPI

which I introduced here recently. (Just type in “Stop Loss” in the search field on my