It often strikes me how there is a fundamental difference between the macro level, and the micro level in Economics and Finance.

My particular style of investing, and reasoning, is a macroeconomic top-down approach, as you might have guessed.  Alternatively there is a bottom-up approach to portfolio construction- something I’d like to be better at.  Sifting through balance sheets and earnings reports, market press releases and cash-flow statements.  Examining financial ratios.

One of my followers Andre Partridge does just this, so if you are interested in looking at the micro-level, firm specific analysis, I recommend you check the blog out.

The world is full of macro risk right now.  A turkey waiting to be plucked and roasted, at least from my perspective.  At some point in the future it is quite likely that the macro risk will recede, and a bottom-up approach would be much more suitable.

Components of Risk in Finance

Generally it is accepted that there are two broad categories of risk in something like a stock.  The alpha (firm specific risk) and the beta (market specific risk).  Models like the Capital-Asset Pricing Model (CAPM) attempt to quantify these components.  Hedge fund managers, or portfolio managers might try to select stocks which are correlated with one another in different ways to hedge against a set of risks and weight their portfolios accordingly.  A perfect hedge would have a correlation coefficient of -1 with the other investment, suggesting no gain or loss would be made on the position, provided the two are equally weighted.

The Capital Asset Pricing Model, showing the expected return, against the beta.  Rm is the expected market return, Rf is the risk-free rate (usually considered to be US T-bills.)

For instance, the portfolio I have constructed this week is weighted more heavily toward a rising stock market index, but I’ve limited my risk by shorting several commodity stocks and ETFs (since this is a hedged portfolio, unlike last week where I was fairly certain about the direction.)

How does this hedge work?  It’s simple really.  If the market rises, I expect that the commodity indexes might rise a little, but not too much given sectoral weakness and I’m alright with that, since my weighting is toward a general upward market trend.  In the event that the markets get panicked by sell-offs, I’ll lose on the long positions most likely (based on their betas) but the commodity positions should lose too. As I’m shorting them I’ll take some gains, which will mitigate my downside risk.

This type of sectoral portfolio hedging strategy does a good job of limiting beta exposure. If you want to hedge the alpha portion, just diversify the portfolio as much as possible.

(Note: This hedging strategy is stock market specific. There are a range of other strategies for currency market risk, interest rate risk, and so on.  Many of these require vast sums of capital.   These are utilized by institutional investors with deep pockets and include the use of futures, options, swaps, and so on.)

Ultimately in the financial markets there is no single “winning strategy”, market characteristics are forever shifting.  Whatever works, works and as long as you’re in the black you’re fine.


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