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 fuc**ng 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 identify 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%

83.8%CH bonds 7.40% 7.7% 0.0278 0.21%

2.0%Non-CH bonds 11.10% 32.3% 0.0451 1.46%

14.2%

Portfolio 10.30% 100.0% 10.30%

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.

Computing RAPMProfit Notional Volatility VAR RAPMUK 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 Liquid Global Investment Letters, I explained in detail why I’m skeptical 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 CPPIwhich I introduced here recently. (Just type in “Stop Loss” in the search field on my investment. comand 

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