Friday, August 10, 2007

Risk Week: All Risks Are Not Alike- Lessons From Hershey Park

As this week has worn on, and I have written about risk each day, the US equity markets have exhibited incredible volatility, while probably ending today up as much as 1%. Our equity portfolio has demonstrated similar performance.

We're not down in the double digits of percentage return this week, or this month. We hold large-cap, S&P500 equities, and call options thereon.

We don't sell calls. We don't sell puts. We don't buy or sell on margin. We don't try to hedge different instruments, in hopes of taking advantage of relationships which are, in general, predictable, but perhaps not so during times of financial uncertainty. We buy no bundles of mixed securities, such as mortgage CDOs, or other CDOs, nor do we buy or sell them in pairs, to hedge their returns.

A few weeks ago, as I spent several days with my daughters at a well-known amusement park in the next state, I mused about how my behavior at that park was rather like the investment behaviors my partner and I evince in the equity markets.

Since we only deal in listed US equities, or call options for them, that means we eschew some very unpredictable instruments which lend themselves to pricing and demand irregularities with frightening frequency.

Similarly, I don't take my children to just any amusement park. Some are rather lax in their admissions security checks and general behavior requirements. Others are less well-known, and subject to my concerns about the safety of some of their rides.

For instance, my daughters and I love to ride roller coasters. We are addicted. Thus, we've spent at least a few days during each of the last few summers at Hershey Park. As I am being rocketed around one of the older, more exciting wooden coasters, I regularly consider how little would be left of all of us if the cars left the track. You basically have no chance of survival whatsoever. None.

Thus, while I engage in the, to some, risky behavior of riding roller coasters, I only do it at a park where I trust the management to operate totally safe roller coaster rides. I never worry about boarding any ride at Hershey. Between the park's long reputation for cleanliness and safety, and the related food operations of the parent, I am confident the company's management of the park brooks absolutely no lapses which could lead to any fatalities or serious injuries on the rides.

Each year, there's a story about someone dying while riding and, falling out of or from, some ride at some amusement park somewhere in the US. But never Hershey.

The lesson I draw from my amusement park behavior, and apply to my investment behavior, is that it is important to set hierarchical, conditional criteria for risk.

We don't invest in instruments other than large-cap, US equities, and the purchase of options thereon (calls in markets expected to remain strong, puts in markets expected to remain weak).

Having set that initial criterion, we remain invested through market turmoil such as these past few weeks. My partner and I monitor the conditions that affect the companies whose equities we may purchase, but we don't worry unnecessarily about the trouble other investors create for themselves through injudicious trading and investing in various esoteric instruments.

That is very germane to this week's market activity. Although some extremists, such as Jim Cramer or Gary Shilling, believe there is a global liquidity and capital contraction which is of systemic proportions, I do not share that view.

Global economic growth and corporate activity remain healthy and robust. Profits are up. Most financial instruments- equities, corporate debt, Treasuries- are in good shape.

The genesis of the current financial volatility and perceived liquidity problems lie primarily with those parties who have chosen to buy, hold, and/or depend upon other parties with positions in relatively high risk instruments involving sub-prime residential US mortgages.

Just a week ago, James Cayne, Chairman of Bear Stearns, got the denial ball rolling by alleging that this is the 'worst debt market in twenty years.'

Only if you happen to dabble significantly in the riskiest, least creditworthy, shallow and illiquid parts of it. Which Bear did.

By Tuesday of this week, other scorched trading and portfolio players, also guilty of expecting constant profit from sub-prime debt, echoed Cayne's claim that the market was unraveling, and, therefore, they had not done anything extreme, greedy or unwise. They were merely victims of a bad market.

Someone would have to fix that bad market. Oh, yes, and, in the process, bail out those who chose to play with that brand of fire labelled 'sub-prime.'

As the French swung into action yesterday, with Paribas' idiotic suspension of redemptions in several of its sub-prime-related funds, and the EuroBank loudly announced its provision of liquidity to their markets, the panic began. Cayne, Cramer & Co. had accomplished their objectives, by causing sufficient uncertainty that counterparties to known holders of sub-prime-related issues stampeded out of positions.

As my partner has pointed out, the actual expected loss on sub-prime mortgages, were they simply to be written off, is far, far less than the total amount of market value destruction seen over the past week in the global financial markets.

Over very, very short periods of time, like the past few weeks, the mass of mediocre, poorly-informed and -reasoning investors, analysts, money managers and pundits can cause temporary market behaviors to depart radically from what more reasoned, informed market participants believe is warranted.

As such, as we have seen recently, volatility can soar, and assets can appear to lose even their intrinsic values. But this is a purely short term effect when there is no serious, structural economic problem underpinning the behavior.

Right now, being in US large-cap equities and options has insulated our portfolio from egregiously magnified losses of those experienced in the S&P500. We still have risk exposure, but we feel it is far, far less than that of investors who have engaged in complex, hedged positions which rely on modeled behavior of prices for esoteric, thinly-traded debt instruments.

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