This is the 3rd and final post in a series on the parallels between farmers and professional risk managers. Read Part 1 of the series on how I’ve come to this conclusion, and Part 2 where I walk through a simple mathematical example of risk-managed grain sales throughout a crop marketing year.
Farmers and hedge fund managers wear different hats but face similar challenges:
Reviewing an opportunity (i.e. what crop to grow vs what security to invest in); and
Deciding how much of that opportunity they want to take on (I.e how many acres are they going to grow vs how many shares / contracts to buy).
Farmers and hedge fund managers face similar challenges:
Reviewing an opportunity and deciding how much of that opportunity they want to take.
However, the farmer wears a lot of different hats within their position (agronomist, mechanic, etc.) whereas a hedge fund manager tends to have people to do the grunt work for them (data analysis, industry research, etc.). Don’t let the hedge fund manager’s access to support and resources deter you: managing market risk is simple and easily attained by both the hedge fund manager and the farmer.
First thing’s first: admit that you don’t know where the market is going. Sure there’s technical risk analysis and an understanding of seasonal swings (and all the mumbo jumbo). At the very core of risk management, it’s about understanding that there are literally thousands upon thousands of factors that will impact a market. Some factors are weighed more heavily against others – but the fact remains that you can’t possibly account for all factors. (Although some may argue that high-frequency trading firms and their trading algorithms are working on it!).
This leads into the second point of price risk management: weighing the positives and the negatives. While technical analysis is important, it often comes down to two things in the cash grain market: supply vs demand. Weighing the upside potential (i.e. bullish headlines) against downside risks (i.e. bearish headlines) provides perspective of what is truly affecting their bottom line.
Weighing the upside potential against downside risks provides perspective of what is truly affecting their bottom line.
Managing Risk Like the Best of Them
Accordingly, the hedge fund manager will weigh these bullish and bearish factors and start to decrease their price risk exposure against the market when:
(1) prices reach new highs or return to previous profitable levels; and
(2) downside risk appears more significant than positive upside price catalysts.
This doesn’t mean that the hedge fund manager unloads their entire position all at once, but rather sells in incremental blocks to extract profit and positive margin when possible. (Good risk managers make sales when they can, not when you have to!).
Finally, a hedge fund manager doesn’t stop managing risk for the positions that are still exposed to the market – even when they have a healthy bank account.
I hear it all the time: “I don’t need to sell”. Maybe the farmer thinks that a decent bank balance means they can leave their grain in the bin and wait for better prices. This is one of the starkest contrasts to the hedge fund manager.
Just because you “don’t need to sell” doesn’t mean you should stop managing your risk exposure to the market.
Just because you “don’t need to sell” doesn’t mean you should stop managing your risk exposure to the market. The literal comparison is a $500 million hedge fund manager with $250 million sitting in cash saying, “we’ve got cash and we’ve got a little bit of ROI right now. We don’t need to worry about the other $250 million still in play.” Any hedge fund manager who manages risk like that will need to be constantly updating their resume (and likely be out of the finance game sooner rather than later).
As I see it, risk management comes down to removing as much emotion from the equation as possible. I’ll admit, this is easier said than done. Especially when Mother Nature is challenging you all the time.
Think about it like this: how do you feel when you make a block grain sale, and then prices go up? How do you feel when you sit on your grain and prices go down?
How many times in the last couple years have you been in a scenario where you’ve said, “I should’ve sold something”?
How many times in your farming career?
The failure to manage your grain’s price risk exposure to the market led to this loss aversion: the worse feeling of not doing anything and the price going down versus the feeling of doing a little something and price going up.
The FarmLead Challenge
With this comes my challenge to you, the farmer, for the 2017/18 growing season:
Be a grain marketing risk manager.
Minimize the amount of loss aversion that you find yourself facing compared to years past. This means doing some pencil farming and literally figuring out where your numbers stand.
Step 1: Take steps to understanding your cost of production. It doesn’t have to be an exact science but getting it down to a number that could be plus or minus $10 – $20 / acre is a great start.
Step 2: Multiply the number of acres by the cost per acre of production to understand your total price risk exposure in the market.
Step 3: Estimate your expected yield of that crop for those acres.
Step 4: Calculate how many bushels equates to 10% of total production.
Calculate how many truckloads that 10% equates to.
Step 5: Divide your total cost of production from Step 2 by the total number of bushels you expect to produce to understand your break-even selling point.
Now you’re ready to start managing your grain’s price risk exposure, even before it’s in the ground.
I would also recommend recalibrating and reviewing this plan during each month of the growing season as the crop conditions and marketing conditions will change.
Remember: admitting that you don’t know what the market is going to do, but weighing upside potential against downside risk should be your focus. Make calculated bets to take profits when they are available and minimize losses (AKA manage your exposure to the market when things look they’re going down).