ETFs Versus Specific Risk – JP Morgan Chase
May 12, 2012
Lets assume you have a nest egg of $50,000 to invest in equities.
As a prudent investor, you are not willing to invest more than 5% of your $50,000 capital in any one equity. This means you will carry 20 equity positions of $2,500 each = $50,000.
The next question is…which equities ?
Do you want to give up control to a stranger, or a family member such as an arrogant, smarty pants brother in law. Or would you rather retain control and make all the decisions yourself ?
Do you have the time and financial background to sift through thousands of financial statements and reams of data to make your 20 selections ? And then, the time to monitor the daily fundamental and technical information on your selections ? …. No ?
Then lets work top down and start with the top 20 equities ( by market capital ) included in the S&P 500. ( AAPL, XOM, IBM, MSFT, CVX, GE, T, JNJ, PG, KO, WFC, PFE, GOOG, JPM, PM, BRK, INTC, MRK, VZ, ORCL. ) You know you are dealing with the ” cream ” of the USA equity market and you know you can probably stay on top of developments just by scanning the financial pages.
Think you are totally safe ?……No …..Still, you are exposed to ” Market Risk ” ( all the boats go out with the tide – market decline ) , Sector Risk ( know anyone who wanted to own airline stocks till recently ) and Specific Risk.. .. The additional unique risk you undertake by owning a specific security whose fortunes rise or fall more or less independently of all other equities.
Lets start there – Specific Risk – By selecting the largest 20 equities in the S&P 500, you have included JPM ( #14 ) in your basket, risking 5% of your capital…..$2,500. I suppose almost anyone would have felt comforted to know they owned JPM instead of C and BAC…especially with all the praise and space Jamie Dimon and his bank have received recently. Mr Dimon even stepped forward to chastise authorities for placing too many proprietary risk restraints on a bank’s ability to make money.
So yesterday when JPM lost 9.52% of its value, Jamie must have felt like he fell into a sink hole. The London Risk Management Section of JPM had failed to recognise and avert a loss of $2 billion in securities hedging derivitive risk, with more news promised. What’s a bank to do to earn money when it ONLY gets 19% interest from us with almost zero interest cost to them ? Remember, lending to business to get the economy going can be a low margin business !! What’s going to happen to the business model ? What’s going to happen to the ” in house quants ” ? They may actually need that math skill to help develop something useful !
By investing only 5% of your capital in JPM you lost ( 9.52% ) -$238. Now that’s Specific Risk, mitigated by the fact that you had 20 different positions of no more than 5% each. What if you had invested your $50,000 in only 10 or 5 positions…..or 1 position ? You do the math.
However, if instead you had invested your $2,500 in the Bank Sector ETF….KBE…you would have lost only $64.50 because JPM is only2.58% of the KBE portfolio of banks. Incidently, KBE as a whole yesterday lost 0.52% ( $130 ) as the sector itself was under some selling pressure in sympathy ( and worry ) for JPM. And that is Sector Risk in action . Investors ask “If that can happen to Chase, what about C , BAC and some of the other even less well run institutions. Maybe we should exit the banks for now ”
Still further, if SPY ( the entire 500 stock S&P portfolio ) had been your $2,500 selection instead of JPM, yesterdays loss would have amounted to only $7.50. That is well diversified specific risk converted to market risk…. in action.
When you talk about specific risk, you also must talk about insider information leaks because the world isn’t perfect and some people would have paid a great deal for pre-release negative information relating to JPM. So, when we are talking risk capital and specific risk we can’t close our eyes to criminal risk. Insider information is the magic wand that converts risk capital to riskless capital. Its also the wand that makes me want to disappear as an investor in individual stocks.
Now I’m not saying anyone benefited from JPM insider information. But, if I were the SEC I’d be reviewing all recent purchases of Put Options on JPM which are not a hedge ( insurance ) against a long JPM portfolio position. Option people know that when you purchase a Put you are either insuring or gambling. Buying naked Puts ( no corresponding long position ) is an extreme form of gambling because the seller has an important advantage over you, the buyer. Not only must the news be bad and market moving but it must hit the market before the option you purchased expires worthless. In this case, you would be betting that JPM would make the $2 billion loss anouncement before the specific options expiry date you selected. Options normally expire the 3rd Friday of the month. The rewards can be huge because you can purchase one Put option contract for a fraction of the market value of the 100 shares in each contract.
What should you take away from this Post.
1) That an ETF is a basket that reduces risk for a private investor vis a vis individual stocks. It also reduces reward by just a bit. but it more than makes up for it by protecting you via … Investing Rule # 1 – ” Preserve Investment Capital ” !
2 ) You show me a purchaser of naked Put options and I’ll show you a fool or a gambler or a probably the beneficiary of insider info.
3) If you must invest in specific equities, split your investments based on the 5% rule.That means 20 x 5% positions. Or. no more than 5% in any position if you carry less than 20 positions.
4 ) That commercial banks should be forbidden to invest. They should borrow deposits from the public to lend money. What that will do is cause banks to lend more because loan interest and fees will be the essence of their business model and the only way they make money . Its time our bankers returned from ” Las Vegas “ even though they will miss the comps and the exciting action of CDSs , CDOs and CMOs. Its time they forget about the next bonus windfall and concentrate on freeing up speculative risk assets to push business loans.
5 ) That Paul Volcker is absolutely on the right track….No commercial bank investing in derivitives ! ! And, fortuitously, this week JPM gave him all the cement he should need to close every risk crack the big banks are famous for trying to squeeze through.
Richard ( Gore ) aka Rich, Dick, RMG, , Richie from Throggs Neck. and Smiley from Woodlawn.