July 21, 2008
THE POWER OF RISK (MANAGEMENT)
Risk and return are the twin sons of Mr. Market, but the equivalency ends there.
Return doesn't lend itself to forecasting, at least not in the short term. But when we look further out in time, there's a bit of transparency at times about what's coming. Meanwhile, risk's a bit more reliable generally when it comes to seeing the future, and that small opportunistic opening gives us a leg up on being completely and utterly subject to Mr. Market's whims.
Shrewdly blending the little intelligence we can gather from the market in terms of risk and return forecasts offers strategic-minded investors the last, best hope for success in portfolio management.
One example: if stocks generally offer a relatively high dividend yield compared with the past, numerous academic studies show that the odds are enhanced for earning higher-than-average returns over the subsequent three to five years and beyond. Mind you, there's no guarantee, but the higher the yield, the better the odds. But we can't rely on this prospect alone, which is why we can't apply this concept to one or two stocks. Instead, we greatly improve our odds of tapping higher-than-average returns by diversifying.
In other words, buying a broad portfolio of stocks at a relatively high dividend yield further increases our chances for beating the buy-and-hold long run performance. Combining the two risk management strategies--buying when yields are high and diversifying the bet--offers more confidence of earning above-average returns than either strategy does in isolation of the other.
We can further enhance our prospective risk-adjusted return by taking the advice above and applying it to multiple asset classes. Once again, we must do so intelligently, by leveraging what we know about risk and it's slightly better odds (compared to pure return forecasts) for extrapolating the past into the future. That is, correlations and volatility matter when considering how to intelligently blend multiple asset classes for above-average results.
If we look to bonds, we know a lot in terms of how they compare to stocks. We don't what the returns of each are going to be, at least not completely, but their relationship tends to be fairly stable over time. One, bonds tend exhibit relatively low standard deviations and correlations compared with equities. Again, that information by itself isn't much help, but it becomes quite useful when combined with what we know about stocks, as per our review above.
Let's say that we're committed to owning both stocks and bonds, based on the fact the two asset classes tend to provide complementary diversification benefits, i.e., one tends to zig when the other zags. The fact that bonds also exhibit low volatility compared with stocks sweetens the diversification deal. Knowing all this, if we also look to buy bonds when their yields are relatively high, we improve our odds of beating a buy-and-hold bond strategy in the long run.
We can take advantage of similar diversification and valuation opportunities by also considering commodities, REITs, currencies and cash as additional components for our portfolio. In fact, we may even find additional risk management value by breaking equities into several constituent parts, i.e., by region, industry or style. Ditto for the other asset classes.
So far, we've only been speaking of risk management in terms of betas, which is to say index funds. But perhaps we can further broaden our opportunities by considering alphas, such as market neutral funds, merger arb funds, managed futures funds, skilled stock pickers, etc.
In addition, if we consider all of our potential choices in the context of asset allocation--choosing portfolio weights for each by way of some economic logic--we may be able to add another layer of risk-management value to our strategic aims. And once the asset allocation is set, the prospect of a "rebalancing bonus" avails itself. Rebalancing in this sense is applying a tactical overlay to the strategic asset allocation in the management of the various asset class components through time. This is yet another risk management tool that can aid our strategic cause.
There are additional risk management applications to consider, but we'll leave it here for the moment. The basic point is that by focusing on risk management, strategic-minded investors can improve their investment results compared to buying and holding the global market portfolio.
Of course, a few caveats are in order. First, there are still no guarantees. It's possible, perhaps even likely that an intelligent investor can wield all of the above and still fall short of the long-run returns available from buying and holding the global market portfolio, which is available to everyone at a very low cost and that requires virtually no adjusting. Why? One reason is that as we blend risk management strategies, we build a more complicated portfolio, and so we must monitor and manage more variables. At some point, we face the hazard of taking on too much. It's tough to make five flawless investment decisions year in and year out; it's even tougher if there are ten annual choices, or 20 or 30. Also, more complicated portfolios incur more transaction costs, taxes, and other real-world frictions that work to our disadvantage. The more active our portfolio, the higher our results must be to overcome the drag. Expenses, in other words, add up and take a hefty toll over time.
Having said all this, let's return to our main point, which is that managing risk is the only game in town. Predicting returns directly, and in isolation of risk management, is a game for fools. Even so, we must proceed down the path of managing risk cautiously, prudently and only after we've done our homework. Each investor must decide how many risk management techniques to embrace. Some--such as diversification--are so basic and fundamental to our interests that we can't ignore them. But to the extent that we are considering adding new layers of risk management to our investment strategy, we should do so judiciously.
Risk, it seems, is our friend and foe. With a little common sense, and an understanding of history, we can keep it in the former camp. But that requires eternal vigilance. Success in risk management can unravel when our backs are turned. Perhaps that's one more reason to consider Mr. Market's global portfolio, which comes fully enabled with a self-sustaining risk management package, and at an attractive price.
Posted by jp at July 21, 2008 9:45 AM