August 2, 2011

Focusing on Volatility: When Risk Management Pays Off

Left unchecked, an excessive focus on risk reduction can threaten your clients’ chances to enjoy sufficient long-term returns to meet their goals. Our recent article for AdvisorOne discussed how this problem may be inadvertently created by advisors who all too frequently spout volatility concerns that can push clients toward overly conservative models, ultimately hampering their future gains. On the flipside of this very real issue, however, it’s important to recognize that a well-managed risk reduction campaign can be effective in limiting downside losses without giving up too much of a client’s prospective upside. 

One of the most effective examples of volatility management is cost-effective control of “tail risk”—otherwise known as unexpectedly large portfolio losses. While no single weapon on its own can combat tail risk, a multi-pronged approach that marries such elements as crisis planning, increasing asset diversification, allocation to low-beta equities and adoption of alternative asset classes can achieve this result. Most important, this fusion of techniques can accomplish what conventional tail-risk reducing strategies cannot do: namely, not curtail high long-term return potential. 

Diversification Evolved: How to Dampen Concentraion Risk
Harkening back to the economic crisis of 2008, many investors were shaken when their traditional diversification across equities, fixed income and real estate failed to adequately protect them from getting burned. But this really isn’t a surprise, given that equities tend to carry higher risk levels than fellow asset classes in the portfolio mix and that many investors use equities to make up the core of their portfolio. Even outperformance of alternatives doesn’t guarantee shelter from overall loss when equities fail. 

A better solution these days may be to dampen concentration risk by
trimming equity positions in favor of exposure to inflation-sensitive investments like commodities and credit instruments in corporate, mortgage and emerging markets. Of course, this concept by no means necessitates creating perfectly equal portions of each aforementioned asset class. But any movement in this direction is a step toward helping reduce overall tail risk. 

Likewise, removing “emotional” reactions to market deterioration is a positive step. Constructing and adhering to predetermined, systematic risk management plans will prevent investors from unwisely clinging to positions as they watch their asset values plummet—only to panic and sell them off once values have hit rock bottom. 

These same emotional investors tend to miss out on opportunities for

gain as well, because they’re slow to reintroduce assets during early signs of economic recovery. The only way to counter these typically human reactions is to install powerful risk-control mechanisms—be they run-of-the-mill stop losses or more complex drawdown control systems. 

In the end, markets rarely exhibit normal distribution and investors are justified in focusing on tail risk, since large short-term losses can indeed prevent portfolios from meeting long-term return objectives. But myopic solutions to tail risk, such as traditional 60%/40%  equity/fixed income models, or allocation plans that incorporate hedging alternatives but still overly favor equities, are seldom wise long-term moves. A fundamental approach involving broad diversification, volatility-based risk management and drawdown control reduces tail risk by enhancing a portfolio’s overall risk-return characteristics.

Disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Information obtained from third party resources are believed to be reliable but not guaranteed.

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