RISK MANAGING AN INVESTMENT PORTFOLIO
By Jerry Tuttle, FCAS, CPCU
2010 Society of Actuaries Speculative Fiction Contest

    Forget all those courses and designations. Risk management? Who is better than I am? If by “managing risk” we mean minimizing volatility, and in particular Value at Risk and down-side variability, I have successfully managed to minimize just about all the risk in my personal stock portfolio.

    Let me tell you what stocks are in my personal portfolio. I have one insolvent company; my broker said he would buy back my 1,250 shares for a dollar – not a dollar per share – a dollar. I have one financial company that had been trading below a dollar a share, so it couldn’t go much lower, until the reverse stock split showed on an adjusted basis it could in fact go lower. I have a satellite radio stock because my kids convinced me that satellite radio couldn’t miss – it’s also trading below a dollar a share. I have what used to be a rock-solid diversified manufacturing company that is just barely trading above single digits. And I have a another stock that trades in the most narrow range you can imagine.

    I would think the beta (ß) of this portfolio is pretty close to zero; it doesn’t matter what the market does, this portfolio doesn’t move. And it certainly doesn’t have much room to go any further down.

    I always thought that building up a stock portfolio would eventually make me wealthy. Now that I am getting closer to retirement, I realize that I need to do something drastic to make this portfolio grow.

    There are over 20,000 unique American Academy, SOA and CAS members. Most of them probably have decent incomes, and nearly all of them list their e-mail addresses. Despite our finance training that says you can’t consistently beat the market, I think every actuary has a nagging feeling that somehow he or she really can. I need to tap into that feeling.

    I thought about that last stock I hold, BJR, currently trading at 20. Not only does it trade in a narrow range, but very few shares trade at all. I decided the time had come to truly manage my risk: If I thought the price of BJR was going up, I should buy call options to buy more BJR at a strike price below the price the stock would rise to, and then sell my new shares plus my existing shares right away to lock in my profit.

    So I devised a plan. I bought the e-mail addresses of the 20,000 actuaries. I chose five stocks from the S&P Small Cap Index: Albuquerque Robotics, Outer Banks Airlines, Marlena Cosmetics, Quintone Publishing, and Lipdom Properties. I chose these from largest to smallest – few people probably even know of these last two. Then I bought 100,000 call options to buy BJR at 20.25 – it was not very expensive to buy the options considering the small increment on the price range.

    Next I sent the following e-mail at 8:00 a.m. Monday to half of the 20,000 actuaries:

“Most of you don’t know me, but I am a fellow actuary. I have a database of over 5,000 stocks. Using techniques of Generalized Linear Modeling, once in a while I believe I can make a very short-term prediction about the movement of individual stock prices, that I would like to share with you. More specifically, I can find one stock in my database that I am willing to make a forecast on for five days from today. Right now, I am thinking that the stock price of Albuquerque Robotics will be higher at the close on Friday this week than it is right now, at this morning’s opening. I am not asking for any money from you, and I am not asking you to even believe me. Just watch the price on Friday.”

    Then I sent the identical e-mail to the other half of the 20,000, except that I changed the key sentence to “the stock price of Albuquerque Robotics will be lower.”

    By Friday, the price of Albuquerque had gone down. I discarded the first 10,000 e-mail addresses, to whom I had given the inaccurate prediction. I took the second 10,000 addresses, and on 8:00 am Monday I sent half of them this e-mail:

“Last week I sent you an e-mail predicting the price of Albuquerque Robotics would go down by Friday close, and it did. This week I like Outer Banks Airlines, but I like it to go up. I am not asking for any money from you, and I am not asking you to even believe me. Just watch the price on Friday.”

    I sent the identical e-mail to the remaining 5,000, except I predicted Outer Banks would go down.

    By Friday, the price of Outer Banks had gone up. I discarded the 5,000 addresses that I given the wrong forecast. I began week 3 with 2,500 addresses to whom I predicted Marlena Cosmetics would go up, and 2,500 to whom I predicted Marlena would go down.

    You can see the pattern and do the math. By week 6, I was down to 20,000 * (1/2)5 = 625 addresses. This time I did not split the group in half, but I sent them all this e-mail:

“Dear Friends. For the last five weeks I have sent you five consecutive accurate predictions of individual stock price movements. Before I give you my prediction this week, I need to tell you that this will be my last prediction. I have mined my database as much as I can, and there are no more stocks that my model seems to work well on. Nevertheless, here it is: BJR will go up this week.”

    I set my Internet browser to Yahoo Finance, where I could watch the real-time price movement of BJR. Of course, as usual, nothing happened. Oh, it moved randomly up and down by ten cents every now and then, but by 4:00 p.m. Monday very few shares changed hands and the price was still 20. By 4:00 pm Tuesday nothing changed. Suddenly Wednesday afternoon some shares of BJR started moving. The price started inching up. Did some of my 625 e-mail recipients decide to act on my forecast? On Thursday a lot of BJR shares started moving, which was unusual for this stock which normally had very little activity. Perhaps the original 625 were inducing others to buy. There were more buyers than sellers, and the price started to rise. By Friday at 3:45 p.m. BJR was trading at over 25. I quickly exercised my call options. Then I sold the stock right away.

    I was about to calculate my profit when the phone rang. It was an investigator for the Securities and Exchange Commission. The SEC had been monitoring me. That said my activities were suspicious, and they told me to meet with them at 9:00 am Monday in their offices.

    I brought my lawyer with me to their office on Monday. The SEC accused me of securities fraud. They said what I had done is called “pump and dump – buy, lie, and sell high.” But I had worked this out with my lawyer long before I sent my first email.

    I explained that I provided predictions, not recommendations. I did not do this anonymously. I did not have insider information. I did not charge money for my predictions. I can provide the equations that back up my predictions. I was stalling on this last point, but I knew I could back into some equations – given enough variables, you can predict anything with multiple regression.

    You could tell that the SEC lawyers were not pleased with this explanation. But I had sneaked between the cracks of their rules, and they let me go with a warning not to do this again.

    I had made a nice profit on BJR. Maybe it was time to retire from actuarial work. I wonder if I could get some part-time work at Albuquerque Robotics?

   

END


Copyright 2009, Jerry Tuttle

Notes:

Author’s note: This is work of fiction, and the events are fictional. The author does not sanction giving stock advice and manipulating the stock market.