There is much discussion in the media these days about risk and whether market participants are embracing either a “risk on” or a “risk off” trading mentality on any given day. What is risk any way? How do you assess whether your money manager is doing a good job managing risk?
Let’s start by defining risk. At Stacey Muirhead, we define risk as the likelihood of permanent impairment of capital. Notice that we did not say anything about volatility. We are quite prepared to accept volatility, perhaps significant, in our short to medium term results provided that we are comfortable that we are not engaging in any investment action that will permanently impair the capital that has been entrusted to our care in the long run. Although much attention is given by academics and the media to volatility as the prime determinant of risk, we think that our definition is more consistent with how most people think about risk in their everyday lives. As an aside, in over 25 years as a professional money manager, I have never heard a client object to upside volatility as in “Hey, Jeff, I am really bothered that our holding in ABC is going up much more than the market. I think you are being too risky!” Clearly not all volatility is viewed as bad or risky!
How do you assess whether your money manager is doing a good job in managing risk? While there are many factors that can go into such an assessment, at Stacey Muirhead one key measure that we utilize in assessing whether we are managing risk appropriately is to evaluate how we do when overall markets perform poorly. While it is possible for one’s capital to become permanently impaired through poor investment decision making in market conditions that are either good or bad, it is our view that bad risk management is more likely to reveal itself during periods of time where markets are performing poorly. As Warren Buffett likes to say, “It is only when the tide goes out that you can see who is swimming naked!”
So how have we done at Stacey Muirhead during periods of time when the markets have performed poorly? Let me deal with the historic record before I discuss how we are faring in 2011. To the end of 2010, we had 17 full years of operating experience with the Stacey Muirhead Limited Partnership. Over that time period we had two losing years as compared to five losing years for the various market benchmarks that we compare our results against (i.e. the S&P/TSX, the S&P 500 and the MSCI World Index). While not a perfect record, it is pretty good and certainly compares very favourably against other alternatives for investor capital. This does not tell the full story however. In the five years that the various market indexes posted negative returns, the benchmarks declined anywhere from 12.0% to 14.5% on average. Over those same five negative years for the market benchmarks, the Stacey Muirhead Limited Partnership managed to post positive results on average. Put simply, we captured none of the downside experienced by the overall markets during negative years over our first 17 years of operation. We are very pleased by this result and believe that it demonstrates that we are effectively managing risk on your behalf.
While 2011 is not yet complete, let me give you some perspective on where we stand using the same tests. As I write this to you, we are down for the year and we are underperforming the three market benchmarks against which we compare our investment performance. It is only the second time in our history where we have delivered poor absolute and relative performance during the same year. Interestingly enough, the last time this happened was in 1999 during the final days of the technology bubble where we had to stoically accept a poor short term result to win over the longer term for you. We would like to think that it is not a coincidence that our poor absolute and relative performance this year is occurring during a period where we have experienced a commodities bubble that we made a conscious decision to avoid and that looks more and more to be coming to an end with each passing day. Regardless of the circumstances, it is fair to state that we have had a less than stellar year with respect to how we have managed risk on your behalf. I should also clearly state that even if this year ends more or less as it currently stands, our long term track record of managing risk remains very good. We will continue to have a record where we have experienced only a fraction of the downside when compared to periods of negative overall market performance.
In summary, while we have not managed risk as well as we would have liked in 2011, our overall record of managing risk for you over 18 years remains very solid. We have always tried to go swimming with our bathing suits on!
“Above the Fray” is a regular blog written by Jeffrey Stacey, Chairman and CEO of Stacey Muirhead Capital Management Ltd., which discusses items of interest related to investing, finance and business. This is not a solicitation.