Duration is your time horizon: how long do you intend to hold a particular investment? Since risk happens over time (sometimes slowly, sometimes all at once!), risk managing duration is key to any dynamic investment process.
In Wall Street-speak, “duration” expresses the expected volatility of your investment, as a function of your holding period. Generally, the longer your time horizon, the greater volatility an investment will experience, and different Durations imply different levels of expected volatility – that’s obvious.
What’s not obvious is that each investment reacts to multiple risk factors across multiple durations. This non-linearity can lead to what we call Duration Mismatch, one of the main reasons investors have negative surprises.
For example, if you invest in a foreign iron ore producer, you might be excited to learn that they strike a major deposit of ore at a time. But what if that happens at a time when the currency in which the stock trades is declining against the dollar? And at a time when China, the world’s major customer for iron ore, is experiencing an economic slowdown? The answer: good company news, but duration mismatch in the currency markets, as the strengthening dollar causes their stock price to deteriorate, and macro-economic mismatch: the decline in the economy of their #1 customer will stick the company with excess unsold product.
How do you risk manage that? By embracing the uncertainty of constantly colliding, non-linear, factors, your plan should always be that the plan is going to change.
In order to proactively prepare for change, Hedgeye focuses on three core durations. We call them TRADE, TREND, and TAIL, to delineate between the immediate, intermediate, and long-term.