Sophisticated investors pay attention when someone brings up the topic of portfolio risk management. Affluent investors are often the most risk averse, perhaps because they have already accumulated enough money during their lifetime to achieve their financial planning objectives. Having reached their accumulation goals, they don’t want to lose their hard-earned gains because the financial…
The current bull market has been steaming ahead since the market bottomed in March 2009. Consumers of investment advice have noted that passive, buy and hold strategies have outperformed most active strategies over this time period, giving some the false impression that ‘risk management,’ in the context of tactically changing portfolio asset allocation to defend against bear markets, is a fools game.
Every Pinnacle client signs an Investment Policy Statement that spells out the long-term targets for risk and reward for each Pinnacle strategy. Risk is presented in absolute terms as a fixed range of returns based on back-testing a five asset-class portfolio from 1972 to the present. The range of expected annual returns (risk or volatility) in the IPS is based on the standard deviation, or the dispersion of returns, from the very long-term average return presented to clients in our now famous (or infamous) Red and Gray charts.
I am often surprised at how the investment industry media finds ‘news’ in investment methods that Pinnacle has been employing for years. This weekend’s Wall Street Journal offered a wonderful example. In a Saturday article entitled, “Same Returns, Less Risk,” Ben Levisohn and Joe Light describe a new investment strategy where portfolio managers handle risk by targeting portfolio volatility instead of a portfolio’s asset allocation. I found this of great interest because we’ve been utilizing this technique for close to a decade. The article identifies three different methods for targeting volatility. It’s worth reviewing them here and pointing out which of the three is closest to what we do at Pinnacle.
What a ride this year has been in the markets. Volatility has been sucked out like water through an unplugged drain, any bad news has been quickly absorbed and discarded, and equities keep gliding to the upside. During this Bull Run, the market has climbed an enormous wall of worry, and has found a way to look more constructive along the way (for example, the S&P 500 broke out of the 2010/2011 range, most global markets recaptured positive trends, and the much maligned financial sector is participating in the current uptrend).
One of our clients recently asked what we thought about high frequency trading in regard to the risk embedded in markets. I responded that dark pools and high frequency trading are not well understood, and in my opinion exacerbate very short term volatility — sometimes at particularly stressful periods in the market. The question is, what to do with this risk? Maybe some of this will eventually be regulated away, but while it’s here the only thing we can do is understand it as part of the current structural environment, hedge our portfolios accordingly, and occasionally try to use it to our advantage.