Good Sight, Good Insight: Risk Management By Ed Seykota
Cameron Hight summarizes an article on Risk Management by Ed Seykota. The article's concepts are central to evaluating the portfolio management prowess of fund managers.
I was discussing portfolio management strategy with a client who runs a long/short equity hedge fund. In his former life, he worked for a large Fund of Funds where he evaluated long/short equity mangers. In that role, he frequently referenced an article on Risk Management by Ed Seykota. He had increasingly become frustrated with traditional manager measurement techniques like VaR, Sharpe Ratio, alpha, etc. He found the article's concepts to be central to evaluating the portfolio management prowess of fund managers.
Fortunately for us, the tenets of Ed Seykota's article are embodied by the Alpha Theory Portfolio Management Platform:
1. Risk is the possibility of loss (not volatility).
2. Hunch-centric betting is certainly popular and likely accounts for an enormous proportion of actual real world betting.
3. Despite almost universal agreement that a system offers clear advantages over hunches, very few risk managers actually have a definition of their own risk management systems that is clear enough to allow a computer to back-test it.
4. To maximize returns, position sizing should be based on a measurement of potential profit, potential loss, and probability of each.
5. Kelly may be sub-optimal for portfolio management because of the diversification effect.
6. Diversification relies on the average security having a profitable expected value.
7. In times of stress, investors and managers access their primal gut feelings (when they should go back to discipline).
8. In actual practice, the most important psychological consideration is the ability to stick to the system. To achieve this, it is important (1) to fully understand the system rules, (2) to know how the system behaves and (3) to have clear and supportive agreements between all parties that support sticking to the system.
9. Profits and losses do not likely alternate with smooth regularity; they appear, typically, as winning and losing streaks. When the entire investor-manager team realizes this as natural, it is more likely to stay the course during drawdowns, and also to stay appropriately modest during winning streaks.