Managing Downside Risk

From both a mathematical and emotional perspective, for an investor pursuing long-term goals, large losses have a much larger impact than large gains. Hence, managing downside risk is a critical part of portfolio management. We believe that an effective downside risk management plan has three key elements.

The first is a portfolio that is well-diversified across broadly defined asset classes, in order to maximize the probability of achieving an investor's long-term real rate of return objective, within acceptable shortfall and other constraints. This requires the use of advanced asset allocation methodologies, as well as techniques to limit the impact of parameter estimation errors. In particular, recent appearance of products that allow investors to directly invest in equity market volatility has significantly expanded the scope for using diversification to limit at least a portion of downside tail risk at an acceptable price.

The second element of an effective downside risk management plan is an automatic rebalancing strategy that keeps actual portfolio weights close to their long-term targets. Our preferred approach is to undertake rebalancing (which incurs transaction costs) only when one or more asset classes has exceeded or fallen below its target weight by more than a trigger percentage (e.g., an actual weight of 5% or 15%, versus a target weight of 10%). For the asset classes most above and below their respective target weights, we also employ an adjustment factor, to rebalance to either slightly below (for the most overweight asset class) or slightly above (for the most underweight asset class) their respective target weights. Assuming mean revision in returns over time, this can add a small amount to a portfolio's long-term compounded rate of returns.

However, while diversification and rebalancing are necessary elements of an effective downside risk management plan (and serve as the basis for all our model portfolios), they are not by themselves sufficient when it comes to risk mitigation. We therefore use a third risk management approach that is based on our assumption that financial markets are a complex adaptive system, in which equilibrium is the exception rather than the rule, and substantial asset class over and undervaluations can (and do) occur. Each month, our subscribers receive our assessment of current and expected asset class valuations based on fundamental factors, investor behavior (momentum), and, at a longer time horizon potenetial our political/economic scenarios. When these multiple perspectives indicate substantial asset class overvaluation and/or an elevated level of systemic risk (as they did in March 2000 and May 2007), we recommend the use of more active risk management techniques, including moving to short term government securities, gold and other defensive positions, and/or the purchase of put options and other derivatives.

This naturally raises the question of how, having moved out of one or more asset classes, an investor should decide when to reverse this action. Our first response is that the extent of this challenge crucially depends on the standard an investor uses to measure his or her performance. If it is an external benchmark, then the investor must worry not only about moving out of an asset class too soon, but also about getting back in too late, lest he or she underperform. In contrast, an investor who seeks only to achieve the long-term return needed to achieve his or her goals faces an easier decision. When an asset class is substantially overvalued, it is far more important to avoid a large loss than to hold out for another month of gains. And when this asset class has substantially declined in price, he or she has flexibility in deciding when to reinvest in it, since its expected returns will be higher than those assumed in the asset allocation analysis that set the long-term asset class weight. Compared to an investor worried about underperforming an external benchmark, this investor will therefore be less likely to reinvest too early. Our second response is that fundamental and scenario based valuation indicators can also be used to help make effective reinvestment decisions.

In sum, effective portfolio risk management is critical to achieving an investor, pension, or endowment fund's long-term real return objective, and the financial goals (not to mention hopes and dreams) that depend on it. In our view, effective risk management is based on a mix of complementary factors, including diversification, rebalancing, use of the long-term return target as the primary basis for portfolio (and manager) performance measurement, constant monitoring of valuation levels, and a willingness to take extraordinary action (like increasing allocations to cash or spending more on put options and similar hedges) when valuations become dangerously high.

You may view Index Investor's Model Portfolio Performance Analyses or continue with a discussion on ETFs versus Index Mutual Funds.

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