Be Prepared

The scout motto tells us to be prepared. My children’s schools practice fire drills and intruder drills as often as monthly. And first responders practice the “be prepared” philosophy as well. At least Boston’s clearly does. I just read an inspirational article in the Wall Street Journal about the preparedness of their emergency medical teams and the speed with which they were able to save people’s lives. “The efficiency of the rescue reflected careful planning, heroic execution and elements of good fortune.” The article went on to state that “Rescuer reaction was so instantaneous that it appeared to be rehearsed.” It appeared that way because in fact, it was. I know of no better way to be prepared than to rehearse. Thespians do it before the curtain rises, politicians do it before a debate and athletes do it before a game. So why don’t more portfolio and risk managers do it before a market crash?

Investor Analytics’ offices are on the 25th floor in lower Manhattan, and this morning we were all summoned to an “Emergency Action Plan: in-building relocation drill.” Not exactly a fire drill – this was more a drill in case of a threat to the outside of the building. Think bomb on the street (we’re 2 blocks from the NYSE), airborne agent or blackout. They want us to gather far from the windows, and the best place in our building is near the elevator bank. Pretty obvious, but still worth practicing.

Image

Employees walking to the elevator area – away from windows – in today’s Emergency Drill.

The same holds for portfolio managers and risk managers, I maintain. Knowing what to do before you need to do it, especially in a crisis, is critical to your success. Having a plan, or set of plans, on what to do in rapidly moving and dangerous markets puts a firm in much better position than trying to figure it out while markets are taking your investors’ money.

One of our clients puts this into regular practice whenever they materially shift the portfolio around in ways with which they aren’t already intimately familiar. I don’t mean when they invest in things they aren’t familiar with: I mean when they have combinations of things they haven’t had before (and that’s almost every day). They perform what-if scenarios on the portfolio with particular emphasis on seeing which securities they can safely liquidate in case of emergency without putting the resulting portfolio into high-risk. It’s as obvious as, during a fire, knowing where the heat is so you don’t go there. Firemen teach children to touch a door before opening it to see if doing so puts them in more danger. Doesn’t it just make just as much sense for a portfolio manager to know if removing a set of positions from the portfolio puts that portfolio at more (or less) risk? During a crash, it may seem obvious that the most volatile positions should be reduced but if those positions hedge the rest of the book, that may actually be a very bad move. Going through such scenarios before the markets force you to act can prevent you from making some big mistakes.

Being prepared shouldn’t be step one in Risk Management — it should come before that!

One Response to Be Prepared

  1. ScribblerG says:

    Wow, I just had an idea reading this article. Imagine building a big risk event simulator which you could use for a “crisis rehearsal”. It wouldn’t have to be the clients portfolio, and in fact would be better if it wasn’t. It’s a better test of the system and people that way. Run them through say 5 days of decision making from mgmt committee to p&l owners to risk managers, or even through a set of progressively more catastrophic events that always blow up on them. Hmmm, sounds like a great business idea.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s