The concept of risk management receives a lot of attention in the investment realm, and rightly so. Chasing return directly, by contrast, is almost certainly doomed to failure. In other words, risk management is the only game in town. But talking about it is one thing; applying it in a meaningful, productive way that delivers satisfactory results is something else. There’s no hard data that tells us how the world practices risk management, but I’m guessing that a surprising number of investors aren’t doing justice to this fundamental concept. With that in mind, let’s kick the tires a bit on what can be a fuzzy topic for the average investor. After all, this is one corner where mistakes are almost always costly if not fatal in a financial sense.
The first issue is simply recognizing what the strategy implies: the management of risks. That’s plural—risks with an “s.” There are countless risk factors that inhabit the money game and every investor has to pick his poisons...carefully. Risk management is always and everywhere multi-faceted. But before you decide what’s important, and what’s not, it’s critical to recognize that you’re destined to oversee, or at least suffer, multiple risks.
Some investors have a habit of seeing themselves as specialists in a particular risk factor—value stocks or market timing (momentum), for instance. In reality, they’re still dealing with multiple risk factors, even if they don't know it. That’s a recipe for trouble. You may be the world’s greatest analyst when it comes to identifying assets trading at a discount, but you also need to pay some degree of attention to the other risk factors that will inevitably play a role in your portfolio, for good or ill.
The goal for all forms of risk management, of course, is producing a reasonable risk premium through time. But that’s a byproduct of overseeing a portfolio comprised of various risks, which must be managed. Why? The short answer is that expected return fluctuates. Today’s high expected return for a given asset may turn negative tomorrow, and vice versa. Why? Because the embedded risk is constantly changing. There are no inherently bad or good assets, only overpriced and underpriced ones, and the reason is because of shifting levels of risk.
What type of risks are we talking about? The sky’s the limit. For some valuable perspective on the breadth of known risk factors, take a look at Antti Ilmanen’s 2011 book "Expected Returns: An Investor's Guide to Harvesting Market Rewards." It’s easy to be overwhelmed by the possibilities. But before you go off the deep end, consider starting at the beginning.
In my view, the primary risk factor is related to asset allocation. If your portfolio is comprised exclusively of, say, U.S. stocks, you’ve made a particular risk-factor decision with asset allocation. The same is true if you hold a portfolio with all the major asset classes, albeit at the opposite extreme of the risk spectrum. Minds will differ on what defines an appropriate asset allocation, but this critical decision, one way or the other, will have a big influence on what you earn (or lose) across your investing time horizon.
How you manage the asset allocation—rebalancing—is another risk factor, and one that’s at least as important, if not more so, than the choice of assets to hold. A third risk factor is your decision of how to access assets—beta or alpha, or perhaps a mix of both? That is, index funds or active management.
Another key risk factor to consider is bound up with the business cycle. It’s convenient to ignore this aspect of investing, in part because the economy is expanding most of the time. But the fact that many risk premiums are positively correlated with the business cycle inspires monitoring this connection with an eye on identifying early warning signs when it appears that the economy is slipping over the edge. Depending on how your portfolio is structured, this can end up as a sizable risk factor embedded in your investment strategy. For that reason, I keep a close eye on business cycle risk by tracking a broad spectrum of economic indicators. I like to call this the mother of all known risk factors; it’s also one of the more overlooked factors from an investment perspective.
Yes, you can go a lot deeper by building portfolios that target a more nuanced set of risk factors. A growing number of strategists argue that risk management should move beyond conventional asset allocation in a meaningful way. The idea of diversifying a portfolio across risk factors, as opposed to traditional asset class definitions, is becoming easier, given the growing list of ETFs that target specific slices of risk. But in a world offering a rainbow of choice for risk management, the first question is still: Why do you think you can add value relative to Mr. Market’s asset allocation? It's tempting to think that this is easy, but in reality a passive asset allocation of everything tends to be competitive, as history suggests.
The record on investment results also suggests that most investors have done a poor job of harvesting the available risk premium that’s linked with a simple mix of stocks, bonds and cash. Quite a lot of the reason is due to inattention, if not outright ignorance, of business cycle risk. In any case, what are the odds that investors will do a better job of managing a dozen risk factors vs. three? I’m not optimistic that progress on this front is fate simply because Wall Street is pumping out more products. But what I do know is that risk management worthy of the name is essential if there’s any chance of generating a decent return beyond next Thursday.