Risk Controls for the Increasingly Nervous

Mike’s wife, Eileen, on the edge of the Cliffs of Moher. Risky!

A few market gyrations or some major stock declines in popular technology stocks will get you thinking about risk again. The last 8 years have been a bit of a sleeper in regard to market volatility so a refresher on risk and how to address it seems due.

Investment risk tolerance varies by investor.

As investors, it is essential that you understand your ability and willingness to take risk, and which risks are most relevant and important for you to address.

Different investors face different risks. For example, if you are 35 and saving for retirement that is 30+ years down the road, should you really care what the market does today, this month, or even this year? Not likely. However, if you are 80 years old and withdrawing funds from your IRA each year to support your living expenses, short-term volatility is of much greater importance. Likewise, a foundation that must distribute 5% per year may have heightened sensitivity to drawdown risk and “return-to-peak” risk.In these cases, the investors need a good understanding of risk and a customized investment strategy that clearly defines goals as well as the ability and willingness to take on risk.

You must take risk to earn returns.

We would all like to find the riskless investment that offers attractive returns. Returns of US Treasuries are often described in finance as the “risk-free” rate of return. Although, there are still risks (e.g. inflation, currency). Capturing greater returns means taking on more risk. Unfortunately, behavioral economic studies around a concept called “Prospect Theory” – which earned Dr. Daniel Kahneman a Nobel Prize – suggests that investors have a disproportionate pain-to-gain ratio. For example, a negative 10% return is twice as painful as the inverse pleasure of a positive 10% increase. We had one client tell us his ratio was 10x!

So, how do investors manage risk with this behavioral tendency? There are simple ways and more sophisticated ways. Let us share a few.

Simple risk controls may cost you long-run returns.

Some investors tend to pull a common set of simple levers to reduce risk. These include the following:

• Increasing fixed income allocation.

  The common approach shifts from equities to fixed income. For example, going from a 70/30 allocation to a 50/50 allocation. However, this reduces long-term expected returns. Worse, studies show that investors are notoriously poor at market timing and hurt long-term returns. And, depending on what fixed income you buy, you may not even reduce portfolio risk.

• Increasing cash balances.

  An investor may feel that the market is overvalued and will hold cash, waiting for more attractive market valuations or a market correction. However, holding cash is actually a speculative move – you are making a market timing call, likely destroying value over the long-term. And, after taking into consideration inflation, cash as an investment has realized negative long-term real returns.

• Retreating to US large-cap stocks.

  This sounds safer, but you miss out on the diversification benefits of small caps, emerging markets, and international developed markets and reduce expected returns. You also may find that US large caps, which are presently dominated by technology/internet stocks, can be risky too (just go back to 1999). It is not that simple.

While these approaches may reduce risk, they go against Modern Portfolio Theory and tend to reduce expected returns as well. Is there a better way?

More advanced risk controls may offer benefits.

Academic research around diversification and asset classes – as well as a review of long-term historical returns – provides some guidance and data for identifying other “non-traditional” ways to address risk. These strategies, which have been used by institutional managers for many years, seek to decrease risk while improving a portfolio’s “Sharpe Ratio” (a measure of return for risk taken). These are not right for all investors, but here are some “tricks of the trade”:

• Utilizing quality/defensive equity strategies.

  Managers employing these strategies generally invest in high-quality companies. That is, companies that have more stable earnings, strong balance sheets, and other “quality factors.” These funds are often less volatile, resulting in lower downside than general markets. Academic studies show that this “factor” or “risk premium” has provided above-market returns over the long term.

• Focusing on shorter-duration fixed income.

  U.S. Treasury and municipal bonds have historically provided “safety” and positive returns during many market corrections. Longer-term duration bonds can be attractive, but they also tend to increase interest rate risk and volatility without sufficient return compensation.

• Pursuing market-neutral strategies.

  These alternative funds seek real returns with zero beta (or market) exposure over a market cycle. These managers often make concentrated investments with the goal of achieving a zero beta – for example, a 100% long and 100% short position in a specific industry or in the broader market. Evidence shows that market-neutral funds are likely to outperform traditional equity funds in times of high market volatility (which also tends to be correlated to declining markets). Here, cost management is essential as costs can erode upside pretty quickly.

• Utilizing managed futures.

  These investments sound mysterious, but the futures market is very large and diverse and has been active for several decades. These strategies have shown an ability to earn expected positive returns in “normal” markets and excess returns in market downturns. With low correlation to both equity and fixed income markets, they help provide diversification benefits to most portfolios. Keeping a long-term perspective is essential.

• Using additional non-traditional asset classes.

  We continue our research into less utilized investment options which are becoming more available to some investors. These include re-insurance, private real estate, private debt, and private equity. These asset classes are often less subject to market performance and interest rate changes, and therefore can help diversify a traditional equity and fixed income portfolio. However, these investments may require a larger capital commitment, come with reduced liquidity, incur higher expenses, and require a longer investment horizon.

Find the Right Combination that Fits YOUR Risk/Return Goals

Not all tools/methods are mentioned here and some of these may not be right for you. Finding the right combination of investments to fit your risk/return goals is how a good adviser can be helpful. Risk management is complex as an adviser needs to address a much wider range of asset-class correlations and return expectations than just a target “60/40” allocation. The potential to improve beyond this should make this statistical exercise worthwhile.