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A visual representation of the digital cryptocurrency Dogecoin, which rallied sharply last week after its supporters encouraged buying of the currency to mark a day celebrating cannabis on Tuesday, April 20. (Photo by Yuriko Nakao/AFLO) No Use China. No Use Taiwan. No Use Korea. No Use Japan.

Yuriko Nakao/Reuters

Spotting signs of froth and speculation in current markets is not hard to do. Every week seems to throw up cases that challenge any precept of rational investing.

One latest example is Dogecoin, a cryptocurrency branded with the image of a Shiba Inu dog that started as a joke in 2013. At times championed by Elon Musk, Dogecoin rallied sharply last week after its supporters encouraged buying of the currency to mark a day celebrating cannabis on Tuesday, April 20. Dogecoin slipped later, reducing its overall market value to US$28-billion from intra-week peaks of more than US$50-billion. But it is still up almost 5,000 per cent since the start of the year.

Elsewhere, another example to emerge has been the stunning rise in Hometown International Inc. HWIN, the owner of a humble deli in Paulsboro, N.J., that recently topped a US$100-million share market valuation. The deli had US$21,772 in sales in 2019 and only US$13,976 in 2020, when it was closed due to COVID-19 from March to September. As hedge fund manager David Einhorn of Greenlight Capital Inc. remarked in a letter to his investors, “The pastrami must be amazing.”

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All that might be entertaining, but as Mr. Einhorn also pointed out, small investors who are drawn into “these situations are likely to be harmed eventually.”

It is also indicative of a lottery ticket approach to investing by many retail investors, buying in the hope of others buying. That, of course, is clear-cut evidence of the top of a market cycle. The question for investors with a greater sense of risk management is what to do now.

Understanding and assessing risk is a crucial aspect of successful long-term investing. Academic studies show that investors feel a loss more intensely than a gain. Yet, risk management is often underplayed.

That’s certainly the case in the world of asset management, in which the acknowledgment of risk often ranks below the goal of generating returns that can maintain client flows and fund the future liabilities of pensions and other long-term liabilities.

Last week, FactSet Research Systems Inc. examined the market rout of March 2020 via a survey of 101 asset managers, insurers and pension plans. The survey identified “a lack of early warning signs within risk analytics as well as a lack of collaboration between risk and those involved in investment decisions.”

That resulted in fewer than half of risk-management strategies performing well during the pandemic among the firms surveyed. Almost half of survey participants reported “significant losses,” with 8 per cent experiencing losses of more than a quarter.

This troubling summary coincided with the publication of a new book, Strategic Risk Management, co-authored by Duke University professor Campbell Harvey, and Sandy Rattray, chief investment officer, and Otto Van Hemert, director of core strategies, at Man Group PLC. The message of the book is that risk management typically becomes the focus of attention only when portfolios are already in trouble from a market shock.

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“The idea for the book is that in a lot of places, risk management is a support function and is not viewed as being part of the investment team,” Mr. Rattray says. “A portfolio manager should be aware of risk all the time.”

Man Group’s quantitative approach helped the hedge fund negotiate the market turmoil of past year in a more resilient fashion than some publicly listed asset managers. So what are the lessons for investors?

When market volatility began rising last year, Mr. Harvey, Mr. Rattray and Mr. Van Hermett say that was a signal to reduce equity and credit exposure ahead of a bigger slide in those markets. “The spike in volatility led to sharp reductions in risk assets,” the authors says.

They also suggest tweaks to another aspect of portfolio management known as rebalancing – making sure exposure to certain assets, such as equities and bonds, remain within pre-determined limits. When equities rise sharply in value, they become a larger fixed share within a portfolio and that usually results in sales of the winners and buying cheaper or lagging stocks.

Rebalancing often occurs at set times, such as monthly or quarterly, and also involves portfolios maintaining a relationship between equities, credit, and sovereign bonds. That approach should be delayed when markets become stressed, so as to prevent a larger drawdown in the value of portfolios as quality stocks are not sold automatically.

Amid an epic run-up in asset prices and with plenty of central bank cash sloshing through the financial system, no one can predict with certainty the timing of the next market shock. But they can look at the various risk signals identified by the authors and use them to help insulate their portfolios and manage their path through a market shock.

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The pay-off from this approach is that a buying opportunity beckons for those who are prepared, while their rivals implement risk management and slash their holdings belatedly.

“The worst time to undertake risk management is during a crisis,” Mr. Rattray says. “You are under stress and that makes decisions hard. It is preferable to be in a position of strength to take advantage of fire sales.”

© The Financial Times Limited 2021. All Rights Reserved. FT and Financial Times are trademarks of the Financial Times Ltd. Not to be redistributed, copied, or modified in any way.

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