Introduction to Risk Management
From both a mathematical and emotional perspective, large losses have a much larger impact than large gains on the probability that you will achieve your long term investing goals. Consider a portfolio with a value of 100 that in Year 1 experiences a 25% loss in value. To return to a value of 100, in Year 2 it must earn a 33% return.
To make this painfully practical, consider this example: If our equally weighted model portfolio had avoided the 2008 market downturn (say, by heeding the warning we published in May 2007), its ending value in 2017 (after 15 years) of an original investment of 100 would have been 454 instead of 322 — a 41% difference.
As we have emphasize ad infinitum since we began publishing in 1997, when it comes to achieving long-term investing goals avoiding large drawdowns is critical.
However, that is easier said than done, because the global economy and financial markets are a complex adaptive system that is constantly evolving, which means that forecast accuracy inevitably declines as the time horizon lengthens. Put differently, investing is no different from many other areas of life, where we have to deal with an irreducible level of uncertainty.
We believe that an effective 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 target within acceptable shortfall and other constraints.
As we have seen, constructing such a portfolio can entail the use of advanced (but still imperfect) asset allocation methodologies, as well as techniques to limit the impact of parameter estimation errors (i.e., the values assigned to expected asset class returns, risks, and correlations or other measures of their interrelationships).
An alternative and much simpler approach is to equally allocate one's portfolio to a mix of passively managed index products that cover a wide range of broadly defined asset classes. Research has repeatedly shown that this is a surprisingly effective technique.
The second element of an effective risk management plan is an automatic rebalancing strategy that keeps actual portfolio weights close to their long-term targets while minimizing taxes.
Our preferred approach is to undertake rebalancing (which incurs transaction costs and sometimes taxes, depending on the accounts in which the assets are held) 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 (typically 2.5%), 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 reversion in returns over time, this can add a small amount to a portfolio's long-term compounded real rate of return.
While diversification and systematic rebalancing are necessary elements of an effective downside risk management plan, they are not by themselves sufficient. We therefore use a third risk management approach, which we call "episodic rebalancing."
This is based on our assumption that because the global macro political economy and financial markets are a complex adaptive system, equilibrium is the exception rather than the rule. As a result, substantial asset class over and undervaluations can and do occur, and in some cases persist far longer than most people imagine.
We further believe that overvaluations are easier to identify than the undervaluations, because in the case of the former there is a wealth of historical valuation data that can be used to inform our judgement (undervaluation involves much more uncertainty).
At Retired Investor, in our global macro analysis we continually assess current and expected asset class valuations based on fundamental factors, the degree of alignment in investor narratives and behavior, and, at a longer time horizon, the potential uncertainty and valuation impacts of the interactions between technological, economic, health, environmental, national security, social, demographic, and political trends and uncertainties.
When our analysis leads us to conclude that substantial asset class overvaluations and/or a very elevated level of systemic risks (as they did in March 2000, May 2007, and late 2019) exist, we recommend the use of risk management techniques that go beyond diversification and rebalancing, such as moving into to short term government securities (i.e., cash), gold and other defensive positions, and/or the purchase of put options and other derivatives to protect against portfolio losses.
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. 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 earn the compound real return needed to achieve his or her long-term 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 if this asset class declines in price to a level below its reasonable value (i.e., if the price correction overshoots), an investor focused on achieving long term goals has flexibility in deciding when to reinvest, since from this low base the expected asset class returns will be higher than those assumed in the portfolio analysis that set the long-term asset class weight.
Compared to an investor worried about underperforming an external benchmark, our long-term target return focused investor will therefore be less likely to reinvest too early.
In sum, effective portfolio risk management is critical to achieving an investor or fund's long-term real return objective, and the financial goals (not to mention hopes and dreams) that depend on it. But like everything else in investing, it isn't easy to do consistently well.
Now let’s move on to the implementation of your asset allocation strategy, and the not-always-obvious distinctions between active and passive investing.