The Antidote To Fear And Greed: Risk Management

Includes: DIA, QQQ, SPY
by: James Picerno

What does last week's market slide across most of the major asset classes imply for investing? A lot…or maybe nothing. The decision to adjust a portfolio, or not, depends on the risk-management strategy.

Every portfolio needs a clear-eyed plan for dealing with risk - it's the financial brain that controls the investment body and provides the map for navigating rough financial seas. With that in mind, now's a good time to review and reaffirm the first principles of enlightened risk management in the care and feeding of conventional investment portfolios.

1. Develop a plan. Yes, that's obvious, but it's easily overlooked. Many investors have a general appreciation of the merits for managing risk (as opposed to chasing return) but don't have a proper plan in place. Vague notions of what you may or may not do don't pass muster. You needn't be a slave to rules, but there should be a clear path for traversing periods of chaos as well as calm through time. This includes a methodology for regularly collecting and analyzing relevant data that's integral to your plan.

2. Recognize that a successful risk-management strategy will be multi-faceted. There are no simple solutions or silver bullets. Instead, there's a zoo of possibility in terms of risk factors from which you'll selectively choose for assembling a customized plan. That said, there are two concepts that typically form the backbone of risk management: asset allocation and rebalancing.

3. Notice the limits of asset allocation. Like any one aspect of risk management, this one has flaws. This implies that you should add techniques that compliment AA's deficiencies.

4. Choose weights for asset allocation that match your goals and risk profile. For what should be obvious reasons, there are no one-size-fits-all solutions here. But there's an obvious place to start: market-value weights, which offer useful reference points on the customizing journey.

5. Rebalance. Plan on adjusting the portfolio mix on a periodic basis. The details will vary, depending on your specific goals, expectations, and other factors. Unless you're an institution with an effective time horizon that's infinite, embrace the practical reality that every allocation requires oversight and tweaking.

6. Design rebalancing rules that are appropriate for you. Any number of inputs will inform your choice. For instance, how much drawdown can you tolerate? Every portfolio needs to be rebalanced on a periodic basis. The details on how and when offer the potential for greatness-and trouble. Proceed cautiously. The standard strategy: systematically return the portfolio to the target weights every year or two. The crucial question: Should you instead deploy an opportunistic plan based on monitoring a set of tactical signals? If so, note the following:

7. Juicing the standard rebalancing rules by adding tactical components to the risk-management plan - integrating moving averages, factors such as value and momentum, etc. into the rebalancing rules - can be productive. But careful planning and oversight are essential. Given the zero-sum reality of markets with respect to benchmark-beating results, most efforts on this front will deliver mediocrity or worse, particularly for return-boosting efforts on an after-tax/cost basis. By contrast, lowering risk is a more reasonable expectation. In either case, a fair amount of R&D is critical.

8. Manage expectations. No risk management plan is perfect and so there will be times when results are disappointing. Meanwhile, align your expectations with the target outcome of your risk-management techniques. A strategy that's focused on limiting the downside, for instance, may look unimpressive before adjusting for risk.