Philippe Jorion’s effective risk management tips for huge returns – Risk management-an important investment tool

“Say you have $1 million invested in a diversified stock portfolio. You would then say: ‘Over the next year, the VAR at the 95% confidence level is approximately $330,000’. You would expect this loss not to be exceeded in 95% of cases, or 19 years out of 20. But in one year out of 20, there will be a larger loss. If you are uncomfortable with this risk profile, you should alter the asset allocation. But at least this will be an informed decision,” he says.

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“Actually, if foreign equities move in opposite cycles to domestic stocks, portfolio risk is reduced. Limiting the amount invested in more speculative assets can also control risk. Portfolio risk is best measured with VAR,” he says.

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“Risk is the dispersion in unexpected outcomes, and not only the occurrences of losses. Countless investors have missed this point, as they failed to realize that the performance of some traders really reflected greater risks. Extraordinary performance, both good and bad, should raise red flags. Ask questions, if only to imitate them,” he says.

“Short options positions collect regular premiums but take a large hit once in a while. Victor Niederhoffer was a legend in the hedge fund business, returning an average of 32% annually from 1982 to 1997. In 1997, he sold naked out-of-the-money puts on the S&P and was wiped out as the market dived. LTCM’s positions amounted to a huge short option position, a bet on volatility and liquidity risk. Similarly, selling earthquake insurance is profitable until the big one hits,” he says.

(Disclaimer: This article is based on Philippe Jorion’s various interviews and speeches)

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