Risk, a long-forgotten aspect of investing, came back to life this year. After more than a decade of easy money and spectacular performance from risky assets such as stocks and cryptos, many hopped onto the bandwagon based on blind faith and hope. No one questioned the kind of risks they are taking. People don't think they can lose or be the last to get out, that is until it happens. And when that happens, they realize they don't have a plan. Or they have one, but never followed through.
So what wakes them up now? Pain. Nothing sinks in more than the pain of losing money. Most people's portfolios are bleeding this year as markets got battered from the twin hammer of rising inflation and interest rates. This year represents one of the toughest markets in decades, so most people, even professionals, are bleeding. Market downturns are part and parcel of the investing journey. This is something we all know. But are there systematic ways to manage the risks so that we don't feel like we are jumping off a cliff when it comes?
Yes, there are many ways to manage risks. And here is a brief outline of 6 such approaches you can take to make your portfolio more resilient in such scenarios.
1. Multi-Level Diversification - Your Only Free Lunch
The first and also the easiest is your good old free lunch (also the only free lunch) - diversification. And I am not talking about just diversifying across a couple of stocks here and there which is what most people do. What I am talking about is multi-level diversification i.e. diversifying across not just securities, but also assets/geographies, and strategies. This is no longer something only large institutions should and can do. Today, everyone can do it given the extensive range of exchange-traded funds and mutual funds available for retail access. If you are interested, you can read more about why multi-strategy diversification works here.
Why do we need such extensive diversification? Because holy grail solutions don't exist. Every asset or strategy can only be the best when it is the right time for them. So you will need a balanced mix of assets and strategies that are uncorrelated to one another to navigate the markets in a resilient way.
To draw a parallel, you can picture yourself as a CIO trying to assemble a team of traders that can make money in a robust and steady way for your fund. Now, if all the traders you picked trade the same style and securities, you are just holding a time bomb in your hand. Because if one fails big time, that means all fail big time. Whether you hire one or ten of such traders doesn't make much of a difference. What you should do is hire traders who trade different styles, assets, and strategies, but are all competent and profitable in their own area. Then they can complement each other. When one is down, others may be up.
2. Risk Based Allocation - Balance Out Your Risk
The traditional way of allocation is based on capital. For example, you may decide to allocate capital across all your securities equally for convenience. Or you may allocate more to securities you think will do better. More often than not, the basis for such decisions is discretionary, meaning it is just based on the person's views.
Such an approach does not take into account the risks inherent in each security or asset. An equal amount of capital allocated to each asset does not equate to the same level of risk. As an example, a dollar of a risky asset such as stock holds a different amount of risk from a dollar of bonds. You can expect the former to be much higher than the latter.
And why should we be concerned about the risks? Because it is the risk that drives the returns and not our views. As hard as it is to swallow, our views don't matter the least bit to the market.
To make portfolios more robust, we can allocate the risks equally among the assets in their portfolios. This is so that all assets drive equally and none dominates. The industry term for such an allocation methodology is also known as risk parity. This avoids the situation of the entire portfolio crashing due to one or two assets going through a rough patch.
3. Volatility Targeting - Maintain The Risk
Ever read about funds deleveraging? What are they doing and why are they doing that? They are basically de-risking because the risk of their portfolio has exceeded their threshold. So they offload their positions across the portfolio to bring the risk level back to their target. As an example, if a fund that targets a 10% volatility for its portfolio experience a spike in its volatility to 13%, they have to reduce its positions proportionally to bring it back to 10%.
Every component your portfolio holds contributes a certain level of risk to the overall portfolio. As risk is a dynamic parameter that changes according to market conditions, your total portfolio risk also changes with time. In peaceful times, your portfolio risk is low. But in volatile times, your portfolio risk can rise rapidly.
Volatility is associated with uncertainty. It surges during periods of panic and fear when a market undergoes a sell-off. These are times when the market expects greater uncertainty ahead. And the high volatility tends to stick around a bit before subsiding. So volatility targeting acts as a systematic protection mechanism by reducing your position sizes when the environment turns kind of hostile. And when volatility falls as the market calms, the positions are added back again to maintain the target portfolio volatility.
4. Rule Based Filters - Put Probabilities In Your Favor
The use of rule-based filters on a portfolio is fairly common. These filters contain pre-defined rules on when and how much you should enter into a particular position. It is just like a strategy that is a macro overlay on your portfolio sitting over and on top of whatever underlying strategies you may be running.
Volatility and trend-based rule filters are some of the commonly applied ones. For example, your core portfolio may comprise a buy and hold across a variety of assets sized according to your desired risk levels. But in addition to that, you also monitor the trend of each asset and you size down or exit the positions of those which are in a downtrend. And when they resume an uptrend, you scale them back up.
5. Stop Loss - Just Cut It
Stop loss is probably the one that most people understood or may already be using. In the most simplistic interpretation, it basically means cutting out a position when the loss exceeds a specific threshold. So a 10% stop loss means you close out a position when its loss run more than 10%. There is also trailing stop loss. These stop loss levels are adjusted upwards as your position makes money so that you get to preserve some of the profits you make should the trade turn against you.
Theoretically, what you do when the levels are breached, is also up to you. If you want a sure-fire hard stop, you can place a stop loss order with your broker. Alternatively, you can monitor the levels yourself. Then you do what you need to do when the conditions are fulfilled. For instance, you may choose to reduce positions and not cut them out entirely.
6. Tail risk strategies - Fight a Swan With a Swan
Unlike fresh investors, most seasoned players are familiar with losses. They are not overly worried about typical losses which are expected of their investments. What they are however concerned with are exceptional losses due to tail or black swan events. These have the potential to wipe out a huge portion of their portfolio. While such calamities don't strike too often, history is littered with enough of them to warrant paying some attention to them.
There are ways to mitigate the fallout from a black swan event. Diversification is one. But some investors may opt to use more explicit strategies to tackle them. And to face off with a black swan, you sometimes need another swan on your side. For instance, a long-only stock investor who has sizable positions in stocks may choose to buy way out-of-the-money put options to act as crash puts. These put options only pay off in the event of a huge crash but when it happens, they pay off big time. Otherwise, they will just expire and you lose all the premium you paid for. Probabilistically speaking, these strategies tend to have a negative payoff in the long run. So some investors may prefer to opportunistically buy protection only when markets are calm. These options will be much cheaper then. But of course, that leaves them vulnerable in the midst of a volatile market.
Aside from buying options, there are also other strategies that can be devised based on volatility to capitalize on the surge in volatility when markets crash.
All Risk Management Comes With Tradeoffs
As an ending note, I think it is important to stress here that there is no single perfect way to manage risks. Every technique comes with its own costs. Some are explicit while others are implicit. If you pay to buy puts as protection, that is fairly obvious. The price you pay for others, however, may not be directly observable unless you model and backtest the risk management strategy. Most come in the form of a drag on your returns. A stop loss may, for instance, cause you to be whipped out of winning trades prematurely. And a trend filter, while useful when extensive trends are present, may get whipsawed in a fast violent market. But ultimately, a good risk management strategy should not cost you significantly. And, in return, you should get more than compensated in the form of reduced risk, lower losses, and a more stable portfolio. So do be realistic with your expectations. Because there will be tradeoffs.
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