4. Your risk system on one page, and the close of the course

Risk 9: A risk system of your own

This is where the course on risk and portfolio management ends. Time to take stock, leave you a tool that fits on a single sheet and tell you where to go next.

The nine levels, one line each

• Measuring risk (level 1): standard deviation describes the width of the calm cloud, not the depth of the hole, and it is not a property of the asset but of the sample you looked at.
• Position sizing (level 2): size weighs more than selection, and the formulas for the optimal size are extremely sensitive to an edge estimated from noise.
• Maximum drawdown and ruin (level 3): the arithmetic of recovery is asymmetric, and the risk that matters is being knocked out before the idea has had time to work.
• Leverage (level 4): it multiplies the outcome and, above all, it introduces the possibility of somebody else deciding when you sell.
• Building the portfolio (level 5): diversifying means spreading risk, not positions, and dependencies tighten precisely when you needed them not to.
• The limits of value at risk (level 6): every figure inherits the defects of the data it is calibrated on, and in calm all the figures reassure you at once.
• The risks that never show up on the chart (level 7): liquidity, custody, counterparty, invisible concentration and operational failure, none of which appears in any volatility number.
• Money through time (level 8): the order of returns changes the outcome when there are inflows or outflows, and the withdrawal rate is a risk decision.
• Your system (this level): limits written beforehand, review at the right frequency and criteria for cutting that do not depend on yesterday's price.

Notice what is not there: any promise of bounding the future loss. That is not a failure of the course, it is its conclusion.

Your risk system on one page

It is not a text to read, it is a form to fill in. If you cannot answer in writing and with figures about your real portfolio, you do not have risk management, you have an opinion.

• What am I really exposed to? The factors, not the names. If rates rise 200 basis points tomorrow, which part feels it and in which direction?
• What is my biggest single bet measured by risk rather than by weight, and how much does the largest common factor weigh?
• How much can I lose in the reasonable worst case, in euros, worked out with scenarios and not only with recent volatility?
• Could I ride out that case without being forced to sell? How many months of spending do I have outside the portfolio?
• How much leverage do I have, including the leverage embedded in products, and what fall can I take before the first margin call?
• What proportion could I sell on a bad day without moving the price against me?
• Who holds all this in custody, with which counterparties, and what happens to me if one of them disappears?
• What would have to happen for me to change my mind, written before rather than after?
• What are my four limits and what date do they carry?
• What do I review each month, what do I review each year and what have I decided never to look at?
• If I am withdrawing money, how much am I withdrawing and what do I do if the first three years are bad?
• How much does all of this cost me a year, in euros, between fees, spreads and taxes?

One page. Reviewed once a year. Amendable only with a date and after a delay.

A worked scenario: the page filled in

An investor with 250,000 euros answers and discovers three things. First: his fifteen positions are really two bets, US technology and the dollar, with 61% in the first. Second: he believes he has no leverage, but two of his funds are target-return funds with borrowing built in, so his real leverage is around 1.2 times. Third: his liquidity outside the portfolio is 4,000 euros, that is, less than two months of spending.

None of those three findings appears in the return, in the volatility or on the monthly statement. All three can be corrected in an afternoon and in calm. That is the entire purpose of the sheet.

Where to go next

• The three easy tracks, without a line of code. Market theory explains the microstructure: what a share is, how the order book works, how to read a company. Macro takes you upstairs: rates, inflation, central banks, the cycle and credit. Costs is the most thankless one and the one that saves the most money, because fees, spreads and taxes eat entire returns without appearing on any chart.
• The other two intermediate courses. Math and statistics turns almost everything that has been prose here into measurable figures: distributions and tails, correlation, significance, multiple testing, out-of-sample validation. Derivatives explains futures and options, with which risk is bought and sold explicitly, and which are also the fastest route to ruin if you have not understood this course.
• The three hard tracks, where you do program. There you learn to source data and clean it, to build a historical test that avoids look-ahead bias and survivorship bias, and to get as far as trading against a real broker. It is the road from having judgment to checking whether the judgment works.

A warning that is not a formality

All of this material is education, not financial advice. Nothing you have read is a recommendation to buy or sell any asset, nor is it tailored to your situation, your objectives or your tolerance for risk. The historical cases illustrate mechanisms, and the fact that something happened that way does not imply it will happen again. Investing carries the risk of loss, including the total loss of your capital. If you are going to decide with real money, do it with your own analysis and, if you need it, with an authorized professional.