When trading, we often focus on individual strategies and their performance metrics, such as drawdown (DD) and compound annual growth rate (CAGR). However, the real power of trading lies in managing a portfolio of these strategies. This blog explores the concept of warehoused risk and how effective portfolio management can enhance returns while mitigating risk. Importantly, it demonstrates a curious conservation law in investing: "Risk cannot be eliminated from a portfolio; it can only be transferred within it." The only way to release risk from a portfolio is by eliminating the risk contribution of an individual return stream by exiting that position.
We will demonstrate why stops, though often criticised as inefficient for mitigating risk, are essential at the portfolio level. They provide risk release valves to mitigate current risk and allow the portfolio to absorb new risk in the future. Not having stops in place can detrimentally affect portfolio performance, especially when market conditions arise that have never been seen before in backtests. These new, unforeseen environments can expose the warehoused risk that exists in a portfolio, which may not have been previously observed.
Single Strategy vs. Multiple Strategies
Consider a single trading strategy on a single market. This strategy might produce a return profile with a 20% drawdown and a 7% CAGR. If we multiply this strategy five times, trading five identical systems on the same market with the same allocation, the drawdown increases to 100%. This happens because the drawdown in each system occurs simultaneously, resulting in a linear relationship between leverage and drawdowns. Multiplying the position size by 5x causes the drawdown to increase fivefold. However, the relationship with CAGR is not linear. While multiplying the strategy 5x might achieve a drawdown of 100%, the corresponding CAGR might only increase to around 30%. This is because CAGR is a path-dependent and nonlinear metric, where increased volatility suppresses compound growth.
Now, what happens if we diversify our approach? Suppose we develop 10 different, uniquely configured trend-following (TF) strategies for the same market. Each of these strategies has a 7% CAGR and a 20% drawdown occurring at different points in time. The portfolio of these 10 strategies might then produce a CAGR of 40% but with a drawdown of only 40%. This is because the risks are spread out due to the lack of perfect correlation between the strategies. The drawdowns of each unique strategy do not coincide, and each return stream offers correlation offsets at different points in time across the entire time series. Furthermore, the CAGR is increased as the volatility drag associated with the drawdown of the entire ensemble at 40% is far less than the alternative of 100%.
By diversifying, we distribute risk across various strategies, each contributing to the overall performance at different times. This risk spreading, due to the lack of perfect correlation, allows for a more stable and robust portfolio, enhancing returns while managing drawdowns more effectively.
The Principle of Warehoused Risk
Warehoused risk is a crucial concept in portfolio management. It represents the total risk present in all return streams, calculated as if each return stream went to zero at a specific point in time. By summing the potential risk contributions of each return stream, we arrive at the total risk summation, known as the warehoused risk of that portfolio at a given moment. This theoretical limit adheres to the conservation law that risk can never be eliminated, only transferred within the portfolio. Another term used to describe warehoused risk is "Portfolio Heat."
Many investors overlook this potential risk lurking in their portfolios—the risk of total collapse if all the risk held by a portfolio is suddenly released at once. Think of warehoused risk as akin to a "risk sponge." The more we diversify and add new return streams to a portfolio, each with the same risk contribution, the more we pack warehoused risk into the portfolio.
Despite the presence of warehoused risk, the risk investors typically pay attention to are measures such as the Sharpe ratio, Sortino Ratio, MAR (maximum drawdown), Ulcer Index, and other risk metrics. These measures are always far lower than the warehoused risk that actually resides in a portfolio. They reflect how individual risks within a portfolio offset each other and how risk events are dispersed across the time series of different return streams. However, these metrics often understate the actual risk potential within a portfolio.
These risk measures typically assess the volatility of portfolio returns over time, a consequence of how discrete return streams interact. Some risks cancel each other out, resulting in a net portfolio variance measure, such as standard deviation or maximum drawdown, occurring at specific points in time. However, these proxy measures understate the possible risks if a new market regime emerges—one that has never been experienced in backtests and significantly alters these risk metrics, reflecting the higher warehoused risk inherent in the portfolio.
Understanding warehoused risk helps investors recognize the potential hidden dangers within their portfolios. By acknowledging this risk and managing it through diversification and strategic use of stops, we can create more resilient portfolios that are better prepared for unexpected market conditions.
The Role of Stops in Portfolio Management
Trend followers often use stops as a critical tool for managing portfolio risk. Stops should be seen as risk release valves for the entire portfolio, preventing warehoused risk from becoming overwhelming due to any contributing return stream in unfavourable market conditions. While some traders argue that stops detract from performance compared to other exit measures, in portfolio management, stops are crucial for maintaining the positive skew of the entire collection of return streams and managing total portfolio heat.
Consider this: in a portfolio comprising potentially thousands of return streams, there is always the possibility that many return streams could suddenly become positively correlated, potentially causing a significant risk event. With stops in place across all return streams, adverse correlations in the portfolio are quickly mitigated through their activation. Without stops and relying solely on historical correlations to mitigate risk, if correlations change, you might suddenly face a significant risk event—not from a single return stream, but from many simultaneously. Thus, we view our portfolios as dynamic risk sponges, continuously releasing risk to prevent adverse events resulting from the way these individual return streams have been combined. This means our portfolios are always ready to take on new risk, unburdened by past risk events that have yet to be released.
For classic trend followers, it’s not the stop itself that guarantees a small risk event per return stream, but rather the small bet sizes. In volatile, fast-moving markets, stops can often be bypassed by rapid, illiquid price moves, rendering them less effective. It is the small bet size that avoids calamity for a trend-following portfolio. Rather than being risk mitigators for individual return streams, stops serve as the chief risk limiters for the entire portfolio. Stops help release risk from return streams that contribute excessively to the overall risk, ensuring that even if market regimes change, the portfolio remains balanced and does not suffer from a single point of failure. This dynamic risk management is essential for long-term success in trading.
Many investors who eschew stops believe that correlations and other metrics provide a better substitute for mitigating portfolio risk. However, this belief is based on the assumption that historical correlations will persist in the future. Unfortunately, markets are non-stationary by nature, and correlations change over time. As a result, risk mitigation measures based solely on correlation management may fail in new regimes never experienced in historical records.
Fortunately, the humble stop, with its ability to eliminate the risk contribution from a single return stream, can be universally applied to the portfolio, regardless of future market regimes. For classic trend followers targeting chaotic, unpredictable anomalies in the tails of the distribution of returns, stops provide a powerful risk release valve in these volatile conditions. Despite the criticism that stops detract from performance, we argue that they are essential and directly contribute to our strong long-term performance.
For the Outlier Hunter, stops are not just tools for individual trade management but integral components of a robust risk management strategy at the portfolio level. By incorporating stops, we ensure that our portfolios can adapt to changing market conditions, maintain balance, and capitalize on opportunities while controlling risk effectively.
Conclusion
Understanding warehoused risk is vital for effective portfolio management in trading. While individual strategies have their own performance metrics like drawdown and CAGR, the true strength of trading lies in managing a diversified portfolio of these strategies. Warehoused risk, representing the total potential risk of all return streams, highlights that risk cannot be eliminated from a portfolio—it can only be transferred within it.
Stops, often criticised for their perceived inefficiency, are essential tools in mitigating current risks and preparing portfolios for future uncertainties. They act as crucial release valves, preventing warehoused risk from overwhelming the portfolio, especially in market conditions not seen in backtests.
Diversification across multiple, uncorrelated strategies reduces overall portfolio drawdown and increases CAGR by spreading risks and offsets. However, many investors overlook the hidden dangers of warehoused risk, focusing instead on traditional risk metrics like the Sharpe ratio, Sortino ratio, and maximum drawdown, which often understate the true risk potential.
Stops play a pivotal role in managing portfolio heat, ensuring that even if market correlations change, the portfolio remains balanced and resilient. They release risk from excessively contributing return streams, maintaining positive skew and preventing single points of failure. This dynamic risk management is essential for long-term trading success.
Despite arguments that other risk mitigation measures may suffice, stops provide a universal solution adaptable to any market regime. For classic trend followers, targeting unpredictable anomalies, stops offer powerful protection in volatile conditions, directly contributing to robust long-term performance.
Stops are not just tools for individual trade management but integral components of a comprehensive risk management strategy at the portfolio level. By incorporating stops and understanding warehoused risk, traders can create resilient portfolios capable of adapting to changing market conditions, balancing risk, and optimising returns.