Chapter 9Mistakes at the Heart of Investment Management

A Common Risk Management Mistake

Jim is a portfolio manager (PM) with a positive track record over the past four years that he's worked for your fund. He began 2016 managing $400 million with a 1% value at risk (VaR) limit and by the end of August was up 10% for the year (+$40 million profit). Given his track record and recent performance you doubled his allocation to $800 million beginning September 1. He can now build a portfolio with as much as $8 million in VaR. Unfortunately, he's run into a rough patch and as of November 1 is down 5% from his August peak (–$40 million from the peak; $0 million on the year). As a result, according to your risk management rules, he must cut his risk in half, which he does. As of December 31, he's back to his high watermark (+$40 million profit).

Table 9.1 shows what Jim's track record looks like for 2016.

Table 9.1 Jim's performance by month and year.

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2016
AUM $400 $400 $400 $400 $400 $400 $400 $400 $800 $800 $800 $800
Notional   $5   $5   $5   $5   $5   $5   $5   $5 –$20 –$20  $20  $20 $40
% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% –2.5% –2.5% 2.5% 2.5% 10%

There's just one small problem. That isn't Jim's track record. It's the track record of your firm's decisions as they relate to Jim's portfolio. Let's delineate all of the decisions that led to those results.

The CIO made four decisions:

  1. Allocate $400 million ...

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