Risk and Amaranth Advisors LLC

Amaranth Advisors is a hedge fund that lost 65% of their portfolio assets in September.  How did this happen?  
People often focus on the rate of return.  However, management of risk is just as important - if not more important in sound investing policy.
 
First off, let me give you what risk means in investment terms.  Risk is the chance that actual return on an investment will be different from the expected rate.  .  Basically, it is the variance each year based upon its past performance.    (Maybe I’d post another topic how to calculate risk.  It is very easy to do if you have had basic statistics, but, for now, I will just describe it.)
 
There are three major types of risk when dealing with equities. 
 
1. Specific risk – risk attributable to factors unique to the specific security.  It also called individual stock risk.

2. Extra market risk – risk attributable to factors to the sector or group of securities that are highly correlated.  For example, technology stocks moved for the most part together.  Or interest sensitive stocks move together.
3. Systematic risk (or market risk) - the variability in a security’s returns resulting from fluctuations in the aggregate market.  The risk attributable to broad macro factors affecting all securities.
 
Specific risk + extra market risk = nonsystematic risk.
 
So
 
Total risk = systematic risk + nonsystematic risk

Nonsystematic risk can be avoided through diversification.  I’ll get into that later. 

Market risk (or Systematic risk) pervades all investments and cannot be avoided or completely eliminated.
 
Market risk can be increased by
1.      Selecting volatile securities. (high beta)

2.      Using leverage
And it can be decreased by
1.      Selecting securities with low volatility (low Beta)
2.      Keeping part of a portfolio in cash. 

Professional investors often are quoted as being “over weighted” in one sector, but the fact that this is being done does not mean it is it is, on average, successful.  There is more risk involved in sector investing since the investor is increasing his extra market risk.  The hope is that the extra risk will pay off with with a higher return.

Other professional manners try to time market cycles and decrease or increase their assets in the market.  They try to decrease their market risk by moving more assets into cash if they think the market is too volatile or going to move downward. 

The amount of risk in a portfolio generally declines as more stocks are added, because we are eliminating nonsystematic risk, or company specific risk.  However, if an investor buys 30 stocks that all move the same direction, the investor is not effectively reducing risk. 

The most effective way to diversify and to eliminate systematic risk is to buy the least correlated performing stocks.  But since most people don’t want to spend the time trying to figure out the covariance and correlation between stocks, the best way to eliminate specific and extra market risk is to buy a total market or S&P index fund.
For those who do buy individual stocks, the rule of thumb many advisors suggest is that no individual stock should compose more than 4% of the portfolio.  This means that a person should have at least 25 stocks if they are going to hold individual stocks.

The truth is that most advisors suggest that investors hold the bulk of their core assets in broad market index funds.  If an investor is more risk tolerant because they plan to be in the market longer or for whatever reason, the investor can then try to over weight a sector, buy a couple individual stocks while not violating the 4% rule, or invest some small percentage of their assets in an index fund of emerging markets which are volatile, which means more risky.  
Now back to Amaranth Advisors LLC and their meltdown. 
They were a hedge fund that invested in commodities.  I am no expert in commodities but the same basic ideas risk applies to the commodities market. 
Amaranth was highly leveraged.  There is an old saying that leverage is all too often the instrument of self-destruction. 

By being leveraged, they tremendously increased their market risk.

Then they made a major speculative move on natural gas, which is a highly volatile commodity.  So they maximized their specific risk as well as their market risk. 
Amaranth apparently looked at potential returns without trying to manage the risks involved.  It is almost like they went to Las Vegas and played the roulette table.  And they lost.  Big. Over 6 billion dollars gone.  65% of their assets gone in one month. 
Now they are going to sell off its remaining assets and liquidate the remaining assets in the fund.