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Proactive Risk Management For Everybody & The One Rule

May 6, 2013

Drama. It’s well-known that “volatility risk” is not the same as “investment risk” and a little bit of thought  – for example, consider watching a swarm of fruit flies go around and up and down, and up and down, until they find a peach pit or a new iThing to buy – should make it very clear that there is no meaning in the daily ups and downs of stock prices that compares to the meaning of losing our money or failing to obtain a return above the rate of inflation, which is the “investment risk”, by definition. If we fail to obtain a non-negative real rate of return, then we will not be able to buy as much later as we can now (because of inflation, which wrecks all fortunes, eventually).

In fact, economists (and even the incomparable mathematician, Henri Poincaré (1854-1912), who is in a class by himself) have been trying to find a “meaning” in the daily ups and downs of stock prices for over 100 years, since at least the time of the French mathematician, Louis Bachelier (The Theory of Speculation, 1900) who thought that they might be “random walks”, but they have come up empty. And should they ever find such a meaning, then we can kiss the equity markets (and the bond markets, but for a different reason) good-bye, because everyone will know exactly not only what the stock price is, but what it must be, instead of merely what it might be, and stocks would trade like “cash” – that is, we’ll give you five twenties for your hundred and a small “commission” for your service.

Enter, the Capital Assets Pricing Model (CAPM), Modern Portfolio Theory (MPT), and the Black & Scholes Option Pricing Model – which are meaningless and provably nonsense, and the economists know that very well, even though the investment industry doesn’t, or pretends not to. Please see our Posts, Bystanders & Collateral Damage and Earnings Don’t Matter, April 2013, for additional information.

The experience of the Canada Pension Plan Investment Board (CPPIB) is illuminating and can serve as a caution regarding the best that we might expect when volatility management and active management are combined to run a global portfolio of $170 billion of which about 50% is in equities, 33% is in bonds, and the balance, 17% is in real assets or “alternative investments” at the present time:

Exhibit 1: Annual Investment Returns of the CPPIB 2004 through 2013

CPPIB Returns Chart

CPPIB Annual Returns 2004 through 2013

With reference to Exhibit 1, the fiscal year 2009 began in the 1st quarter of 2008 and ended in March 2009, and therefore reflects the loss of -20% of the investment – on paper, if there were no liquidity concerns – and the subsequent “gifts” from a buoyant equity market for the next four years, including the first quarter of 2013 which tended to lift all boats by about +12%.

Moreover, there’s nothing that they can do about the uncertainty of their returns because the less exposure that they have to volatility, the less likely it is that they might obtain “excess returns”; and if they do, they are “unexpected” returns and could be either grossly positive or obscenely negative, with no explanation absent externalities.

For example, if we squeeze the toothpaste only in the middle (“reverting to the mean”), ever more finely, and don’t take any out, where does it go? Yes, it goes to the “tails”, and it might be a while before that shows up, but it will.

If the CPPIB wants to keep their +$30 billion of investment gains, they need to think about taking it out, perhaps by buying RRBs (real return bonds), or giving it back to the pensioners – who are their shareholders – and putting it back into the economy at large, rather than giving it back to the stock market; and doing it all again, this year, with just $140 billion plus an inflation adjustment so that the capital remains intact.

In our view, the benchmark is not “returns” on gross amounts of money, but how much are we being paid for our money every year?

Proactive Risk Management For Everybody – The One Rule

We have shown elsewhere (please see our Post, Bystanders & Collateral Damage, April 2013, for references) that the (B)-portfolios that we call the Perpetual Bond™ have the property that they tend not to lose in value, and, equally importantly (for reasons of the theory), that the Contra Portfolios that we call the (N)-portfolios, tend not to gain in value, and (we show further by a different method) that a company can be included in a (B)-portfolio if and only if the ambient stock price appears to be at or above the “price of risk”, which we correctly, both in theory and practice, calculate from the company’s balance sheet as the Risk Price (SF).

The One Rule, then, is that a company is rated a (B) if and only if the ambient stock price, which we usually summarize as the Stock Price (SP) (and it can be any stock price at which we are able to buy and sell the stock), is plausibly at or above the current Risk Price (SF) which changes, or might change, only as new balance sheets become available, but it could be calculated as often as we like because a company always has a balance sheet (and not just every quarter).

The Cash Flow Chart (Exhibit 2 below) shows the result of applying the One Rule to all of the companies of S&P 500 with a market capitalization in excess of $1 billion – we’re thinking big, here, and don’t need to sweat the small stuff , “small caps” for excess returns; and, in fact, we prefer to work with a market capitalization in excess of $20 billion with is still more than 150 companies, worth $10 trillion, and good for better returns than the small caps. Exhibit 3 shows the actual portfolio as extended from September last year through to the end of March and April this year.

The return on the Perpetual Bond™ in 2012 was +22% plus dividends, and it contained 247 companies (please see the Total line and the Count line in Exhibit 2); the scale of the Chart can be anything from 000’s, to millions, to billions, without upsetting the market; the prices are just the sum of the stock prices Stock Price (SP) at which we “buy” a company on an (N)- to (B)-transition and don’t sell it until a (B)- to (N)-transition, with our usual “selling discipline” in force (either a stop/loss or a “collar” on our long position; please see almost any of the (B)(N)-Company Posts).

In this example, we bought 177 companies at the market price at the end of December 2011 for $9,528,000 (in blocks of 1,000; please see the Total line) and ended up with 247 companies a year later and a net portfolio value of $11,625,000 for a +22% gain on capital; if we had just bought all of the companies on the same basis, the cost in December 2011 was $17,951,000 and the current value is $20,655,000 for a capital gain of +15% (plus dividends); and the change in the market index was +12%. The Cash In and Cash Out lines summarize the selling and buying activities (respectively) from the Cash Account which shows a negative balance only if we choose to use the margin account (which we do here, for clarity) and the Total line is the sum of the Portfolio value ($14,385,000) and the Cash Account (which is negative $2,761,000).

Exhibit 2: Proactive Risk Management – 2012 Perpetual Bond™ – Cash Flow Summary

Proactive Risk Management - Cash Flow Summary

Proactive Risk Management – Cash Flow Summary

(Please Click on the Chart to make it larger if required.)

The Change lines at the bottom of the chart show the month-to-month and quarterly changes in the Total line, and those can be compared to the month-to-month changes in the Index line.

Some of the portfolio returns are negative, but in practice, that is negligible and controllable if the “selling discipline” is reasonably well applied, and the “selling discipline” is itself a profit center. This portfolio returned +11%, -1%, +7% and +4%, quarter-over-quarter in 2012, and we know exactly how that was done, and we can expect to do it in perpetuity as long as there is a functioning market for “equities” somewhere in the world – “volatility” and the “markets” (externalities) have nothing to do with it.

Exhibit 3 (please see below) shows the company ratings as (B) or (N) since September of last year through the end of April. On the left is the Stock Price (SP) at which the company was bought on an (N)- to (B)-transition, or subsequently held, and, subject to the “selling discipline”, the price at which it was sold on a (B)- to (N)-transition. The $GAP is the difference between the current stock price and the current Risk Price (SF); the Delta is our estimate of the quarterly downside volatility that might be expected in the stock price, and the $Stop/Loss is the price at which we set the stop/loss if there are no options in effect (it is shown in red if less than the current Risk Price (SF) but the stock price isn’t); and the CHG is the percentage price change since December. (Please Click on the Chart, and again, to make it larger if required.)

Exhibit 3: Proactive Risk Management – 2012/2013 Perpetual Bond™ YTD – Portfolio Summary

Proactive Risk Management - Portfolio Summary - May 2013

Proactive Risk Management – Portfolio Summary – May 2013

(Please Click on the Chart to make it larger, and again, if required.)

The One Rule

The calculated Risk Price (SF) is a provably effective estimate of the “price of risk” which is “the least stock price at which the company is likeable” (Goetze 2009) and “likeability” is determined by the demonstrated factors of “risk aversion” – we want to keep our money and obtain a hopeful return above the rate of inflation – and the properties of portfolios of such stocks.

Stock prices that are less than the price of risk can be said to be “bargain prices” but with the risk attached that the company might never get a higher price other than that due to ambient volatility or “surprise”; on the other hand, investors who are willing to pay the “full price” above the price of risk, and buy and hold the stock at those prices, must also be confident, and have reason to believe, that the company will produce those values, absent new information.

Please see our Posts, The Price of Risk, August 2012 and The Nash Equilibrium & Its Stock Price, October 2012, for more information on the theory; and for our view of the current markets, The Wall Street Put, April 2013, and earlier Posts such as The Dow Transports, March 2013, or The Risk Adjusted Dow, March 2013, or The Canada Pension Bond, February 2013. For a more colorful description of investment risk and the application of the “price of risk” to mergers & acquisitions, please see our Post, Bystanders & Collateral Damage, April 2013.


We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond
“Alpha-smart with 100% Capital Safety and 100% Liquidity”
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to


Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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