RISK MANAGEMENT
You don’t need a
PhD to manage risk
If it’s true that what goes up must come down,
Canadians should start defending their financial gains.
By David Derwin
M
     
risks on a daily basis, even if they
don’t work in a corporate treasury
setting or in the financial industry. How so, you
say? Well, let’s consider the current state of the
equity markets.
Table 1
Proctor & Gamble – down 40%
Intel – down 45%
Home Depot – down 48%
DuPont – down 51%
Microsoft – down 55%
Over the past 10 years, the   Total Return inApple – down 70%
creased by over 15% annually, and the   increased
by over 20% annually. This increase in value
Bottom line is it can happen, it has hapin the   is comparable to the rise in
pened and most likely it will continue to
the stock market of another industrial, -
happen.
country, Japan, throughout the 1980s. FigMany people are invested in stocks in
ure 1 compares the Japanese Nikkei 225
some form or another either through mustock index between 1974 and 1989 with the
tual funds or their pensions. For instance,
  from 1984 to present:
the 10 largest balanced mutual funds own
Unfortunately, as we all know, after 1989,
60% in stocks and 40% in bonds and cash.
the Japanese fairy tale did not have a happy
A survey of the 100 largest pension funds
ending.
reveals that they hold 60% in stocks, 35%
So what does all this mean? Well, if the
  continues to mirror the Nikkei 225, A survey of the 100 in bonds/cash and 5% in other. These are
the   could drop in value by 50%. largest pension funds not insignificant propor tions held in
stocks.
And, considering the high correlation bereveals that they
What does all this mean for you and
tween Canada and the U.S., the   hold 60% in stocks,
your
investments? Well, if the general stock
index would likely drop as well.
35% in bonds/cash
market
drops by 50%, you would need to
Impossible you say? Well, there are many
and 5% in other.
double your money just to break even. So
precedents for this type of event. One is the
above-mentioned Japanese stock market of the late 1980s, how long could this take? Well, if the markets move
which is still down half of its value of over a decade ago. Fur- back to their long-term average annual total returns of
thermore, the high technology  index is down almost approximately 10%, it would take over 7 years. But this
40%. Furthermore, specific examples of falling prices of even is a best-case scenario where stocks would rise at their
blue-chip companies are occurring around us every day. long-term average market total returns. What if, inFollowing is a list of companies that have had significant stead, the long-term average returns did not materialize? In Japan, stocks are still down 60% almost 11 years
percentage drops from their highs as of October 13, 2000.
10 CANADIAN Treasurer
DECEMBER 2000/JANUARY 2001
RISK MANAGEMENT
Figure 1: Nikkei 225 vs. S&P 500 — Correlation 99%
1000
900
Figure 2: Nikkei Index
S&P 500 Oct. 1984 to Sept. 2000
40
Nikkei 225 vs. S&P 500 — Correlation 99%
35
800
30
Index (000’s)
Index
700
600
500
400
25
20
15
300
200
10
100
0
5
Year
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
The increase in value of the S&P 500 over the past 10 years correlates to the rise in Japan’s stock market throughout the 1980s
(Figure 1). In Japan, stocks are still down 60% almost 11 years later (Figure 2).
later (Figure 2). If this situation materializes
here in North America, then obviously it
would take much longer for your capital to
return to pre-existing levels.
So, if you do hold stocks, you must remember that the gains that have accrued over the
past few years are only paper profits. You have
not made money until you put the cash in your
pocket. This is especially important if you are
in your 40s or 50s and plan to retire in 5, 10 or
15 years. The value of your portfolio, after a significant drop, may not be enough to fund the
future cash flow needed for your retirement.
CANADIAN Treasurer
You have not
made money
until you put
the cash in your
pocket. This
is especially
important if you
are in your 40s
or 50s and plan
to retire in 5, 10
or 15 years.
This article is not meant to alarm or scare,
but rather to make you think and consider
some common sense views on investing and
risk. There comes a time when you need to
concentrate on risk and not just returns.
Now is a time to play defense, manage the
potential risks and focus on capital preservation.
DECEMBER 2000/JANUARY 2001 11