Risk and Money Management When Investing in China

04
Oct

One of the most common misconceptions among investors is that to succeed, you have to be right more frequently than you are wrong. That is hardly the case, whether we are referring to Chinese assets or any other asset class. For example, you can be right 9 out of 10 times and generate 1% each time, yet lose 30% that one time you are wrong… all of a sudden, it becomes abundantly clear than being right is hardly a universal panacea.

The same way, perhaps only one out of ten trades ends up becoming profitable and that is perfectly fine as long as you make more money through that trade than you have lost due to the previous nine. To put it differently, the common denominator among successful traders and investor tends to be proper risk and money management much more frequently than some “magic” ability to foresee the future.

Compared to other jurisdictions, especially Western ones, China tends to have much more of a “Wild West” element attached to it. On the one hand, there are ample opportunities to generate staggering profits but on the other hand, there are quite a few traps one doesn’t come across as frequently as in the West, anything from legislative uncertainty to endogenous shocks.

As such, perhaps even more so than elsewhere, risk and money management is paramount in China. Make no mistake, there will eventually come a time when you will make a painfully wrong call or a series of painfully long calls no matter how successful you are. If your risk/money management framework doesn’t permit that, it’s time to get back to the drawing board.

When investing in Chinese assets or any other asset class for that matter, the name of the game is not just finding potential trades with a risk to reward ratio that is asymmetrically in your favor but also being prepared for even “once in a lifetime” trades to go sour. No matter what your strategy revolves around, whether it is fundamental analysis, technical analysis, anything in-between or a combination of both, it is vital to comprehend that not even the best strategy in the world provides certainties.

If someone offers you the opportunity to double your money on the outcome of a coin toss, the smart approach from a risk and money management perspective is simply saying no. Where is your probabilistic edge if you “just” double your money on a 50-50 event? Needless to say, it is just not there. Let us take things one step further and assume someone offers you the possibility of making ten times the amount you are putting on the table on that same coin toss. In other words, a 50-50 event where if you lose, you are only out let’s say $100,000 but if you win, you make $1,000,000. Needless to say, this would be a silly thing for the other party to offer and an amazing opportunity for you from a probabilistic perspective.

However, even in such instances, there are no certainties.

You might end up simply being unlucky and even if the coin has in no way been doctored, it could happen that after five coin flips, you get none of them right. As such, the other party ends up taking your money despite stupidly letting you take advantage of an arrangement where he was at a clear probabilistic disadvantage.

Your risk analysis needs to revolve around the fact that yes, such opportunities are worth taking because they put a solid risk/reward ratio on the table but on the other hand, also acknowledge the fact that no matter how PROBABLE it is that you end up profiting, it is still POSSIBLE (however unlikely) for the exact opposite to happen. As such, the money management dimension needs to kick in, with you deciding to never bet the farm, no matter how asymmetrically in your favor a certain trade may seem.

Time and time again, brilliant macroeconomic analysts ended up losing money despite being “right” for the simple reason that their timing was off and in the absence of proper risk/money management, they might have even ended up being wiped out completely. The same way, think about the risk analysts who recklessly encouraged insurance companies to accept considerably more volume than they should have when insuring “safe” (or so they thought) products such as the (in)famous Mortgage-Backed Securities through the just as (in)famous Credit Default Swaps. These insurance companies employed some of the most brilliant economists and mathematicians out there but the arrogance of those individuals (who blindly trusted overly-optimistic models) corroborated with a shocking lack of humility made clear by the improper money management approach that was chosen ended up bringing about insolvency, with the insurance companies in question ultimately having to be rescued by the average taxpayer in the aftermath of the Great Recession.

Whether you are an average individual who is interested in gaining exposure to Chinese assets or an institution that manages 8 to 10-figure accounts, risk and money management will make or break your strategy. For this reason, the ChinaFund.com team is at your disposal for all of your financial modeling needs as well as anything else that can provide value to the due diligence dimension of your money and risk management process.