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August 02, 2011 at 06:13 AM
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.
