Create a safety net to minimize any crashes
Published May 13, 2023 • Last updated May 15, 2023 • 3 minute read
FP columnist Martin Pelletier is an avid mountain biker and has learned the hard way how to adjust for risk. Photo by Gavin Young/Postmedia Being an avid downhill mountain biker and skier, I learned the benefits of defining and assessing risk the hard way rather quickly, but many ignore risk when investing or get their assessment wrong when trying to understand what it truly entails.
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Access articles from across Canada with one account. Share your thoughts and join the conversation in the comments. Enjoy additional articles per month. Get email updates from your favourite authors. Risk is the possibility of something unpleasant or unwelcoming happening weighed against the reward being offered by certain activity. In the case of investing, it is the probability of locking in a permanent loss, while in adventure sports, it’s the chance of permanent injury.
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It’s important for investors to realize that the greater the variability of your returns, the greater the chance of making a mistake because of emotions entering the decision-making process. Think of it this way: the steeper the mountain, the greater the speed involved, and the more turns and objects you need to handle, all of which creates a higher likelihood of crashing.
Measuring the standard deviation of your portfolio is a good initial indicator of how steep the risk curve is as well as the overall level of risk being taken onboard.
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Article content Ideally, you want a portfolio manager who will create what is called a positive asymmetrical return profile, which refers to a strategy that aims to provide higher potential returns than potential losses.
This essentially creates a favourable imbalance between profit and loss, or positive and negative returns. As a result, there is a safety net in the event of a crash that minimizes the chance of your portfolio undergoing an injury that prevents it from achieving its overall objective.
Last year was an excellent chance to evaluate your portfolio because if it fully tracked a passive benchmark during a negative event, such as high inflation and the corresponding rapid rise in interest rates, there was no such safety net and, therefore, little to no risk management being offered.
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Article content In such a case, you are simply better off owning the market passively and doing it yourself rather than paying fees to have someone steer your portfolio.
This is because stock market returns by default are asymmetric given they have what are called fat tails, meaning there can be huge gains or losses at both ends of a distribution curve. Fat-tail events are rare, at more than three standard deviations from the mean, but they can wreak havoc on a portfolio when they happen. Worse, you react by trying to time the market, thereby locking in those losses.
This is why it is important to employ tail-risk hedging within your investment portfolio. As risk managers, we deploy such strategies via structured notes that have embedded downside barriers, as well as tactical asset allocation.
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Article content For example, having long-dated U.S. Treasuries provided excellent downside protection during the March 2020 COVID-19 meltdown. More recently, we were able to provide flat performance last year in our balanced strategy, while most 60/40 portfolios fell by 10 to 15 per cent, by greatly reducing our duration exposure within both our bond and equity positions, as well as by adding a slice of inflation protection via a 10-to-15-per-cent weighting to energy.
Looking ahead, not surprisingly, those who fully participated in last year’s correction are now advising people to double down and take on extra-long duration to try to recoup those paper losses. This is a classic example of what we call loss aversion in our business. It could possibly work out, but it nonetheless adds more risk to your portfolio.
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Article content Market changes in progress, gaining steam make for interesting times 6 ways to make more income from your investments It’s time to revitalize your portfolio with a little thrift Making bets in an attempt to capture the right side of a low-probability, fat-tail event because you participated on the wrong side of a negative event is not something we’re interested in doing. We much prefer an approach that reduces the variability of your portfolio and maximizes the probability of achieving your target return independent of what everyone else is doing.
Or, as Benjamin Graham famously said: “The essence of investment management is the management of risks, not the management of returns.”
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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