Ladies Love Low Risk

by: David Pinsen


Studies show women investors are more risk averse than men, which raises concerns that they will get lower returns by avoiding equities.

The typical solution proposed is education, but we argue it's more constructive to take steps to actually limit risk. Don't just read about the flu, get a flu shot.

We layout a method of strictly limiting risk while maximizing expected return, and offer a sample hedged portfolio. We also discuss some unusual securities that appear in it.

Studies Show Women Are More Risk-Averse

In a recent column ("Reckless caution of women investors"), Claer Barrett (pictured below; image via the Financial Times) noted that efforts by the wealth management industry to gather assets from women investors tend to run into a challenge: women are, on average, more risk-averse than men.

Here, Barrett summarizes the results of the studies on risk tolerance and their implications for women investors:

The fact that women are more risk averse than men is backed up by many studies, the most recent being a YouGov poll for Boring Money, the consumer investment website set up by Holly Mackay. She worries that this means many women are missing out on the long-term potential upsides of the stock market.

The solution Barrett suggests is education, but will education alone encourage the risk averse to invest in stocks? That seems unlikely, particularly if, during their education, they learn that between 1980 and 2014, 40% of stocks suffered catastrophic losses of 70% or more without recovering.

Instead Of Just Educating, Why Not Actually Limit Risk?

Barrett isn't alone in offering education as a solution to risk aversion. In a CNBC interview last summer, financial planner Marguerita Cheng, CEO of Blue Ocean Global Wealth, emphasized the need for education for another group of risk averse investors, millenials. But the focus on education seems odd when you consider risk in non-financial contexts. For example, consider the risk of catching the flu. If you were risk-averse about that, you probably made sure to get yourself a flu shot. Rather than just educate yourself about it, you did something to limit your risk. We think a similar approach would make sense for risk-averse investors, whether they are men or women.

Risk Tolerance For Men And Women

What's the largest decline you would be willing to risk over the next six months? We refer to that as your "threshold". Each individual has his or her own threshold, but as we mentioned in a previous article, according to data from Riskalyze, the average threshold for US investors is 11%; i.e., the average investor is unwilling to risk more than an 11% drop over a six month period. We didn't get threshold figures broken out for women investors, but presumably, given the studies Barrett cited above, it's less than 11%. Let's assume for now that the average woman investor's threshold is 10%. Below we'll show a way of investing while strictly limiting your downside risk to 10% over the next six months.

A Flu Shot For Your Portfolio

The simplest way to strictly limit your risk to a drawdown of no more than 10% over the next six months would be to keep 90% of your portfolio in cash. Even if the rest of it went to zero, you would only be down 10%. The advantage of this, in addition to its simplicity, is that it doesn't cost anything up front. Of course, the disadvantage to using cash to limit risk in this manner is that it's a huge drag on returns in the absence of a catastrophe, which is what advocates of investor education are trying to avoid.

Another approach would be to hedge each position in your portfolio against a >10% drop. The disadvantage of this is that hedging has a cost, so it's important to try to minimize that cost. The advantage of this approach is it lets you concentrate your assets in securities that have higher potential returns than cash.

Limiting Hedging Cost Versus Maximizing Potential Return

If you calculate the hedging cost of very optionable security in the US, and sort for the ones that are cheapest to hedge, the names that come up as the absolute cheapest to hedge generally have low potential returns. For example, the name topping our cheapest-to-hedge list as of last week was Symetra Financial (NYSE:SYA). It had a 0% potential return, because it was about to be delisted, pending the completion of its acquisition by Japanese insurer Sumimoto.

On the other hand, if you estimate potential returns for every optionable security, the ones with the highest potential returns may also have high hedging costs. So what we do instead is to calculate potential returns for securities and then subtract the costs of hedging them to get potential returns net of hedging costs, or "net potential returns". The essence of our hedged portfolio method is to buy a handful of securities with the highest net potential returns, and hedge them in accordance with your risk tolerance.

A Sample Portfolio Hedged Against A >10% Drawdown

If you had $1,000,000 to invest, and were unwilling to risk a drawdown of more than 10% over the next six months, this is the hedged portfolio our site would have presented you as of Monday's close, to maximize your expected return while strictly limiting your downside risk to no more than 10%:

Why These Particular Securities?

As of Monday's close, Agnico Eagle Mines (NYSE:AEM), Activision Blizzard (NASDAQ:ATVI), Hawaiian Holdings (NASDAQ:HA), Public Storage (NYSE:PSA), Raytheon (NYSE:RTN), the iPath S&P 500 VIX Futures ETN (NYSEARCA:VXX), and the Daily Direxion Daily 3x FTSE China Bear ETF (NYSEARCA:YANG) were all among the highest-ranking names in the site's universe when sorted by net potential return.

Let's pause here to note that it's been unusual for bearish exchange-traded products to end up among our top names, because they tend to have bad long term average returns. For example, YANG returned -19% during the average six-month period since its inception, and VXX returned -27%. But it's been an unusual time in the markets, both ETPs have strong recent returns and are inexpensive to hedge, and we practice agnostic security selection during market inflection points.

The site rounded down dollar amounts to get round lots of each of the securities above, and then, in the fine-tuning step of its portfolio construction process, allocated the leftover cash from the rounding down to another bearish ETF, the Direxion Small Cap Bear 3x Shares (NYSEARCA:TZA), which it added as what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications. Let's turn our attention now to the portfolio-level summary, starting with the most important part for risk management purposes.

Worst-Case Scenario

The "Max Drawdown" column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 9.62%. That 9.62% maximum drawdown is inclusive of the 2.44% hedging cost shown in the portfolio level summary, i.e., the portfolio value would only be down 7.18% not including the hedging cost, in a worst case scenario.

Best-Case Scenario

At the portfolio level, the net potential return is 13.72%. This represents the best-case scenario if each underlying security in the portfolio meets or exceeds its potential return.

A More Likely Scenario

The portfolio level expected return of 4.71% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns.

Each Security Is Hedged

Note that in the portfolio above, each underlying security is hedged. PSA and RTN were hedged with optimal puts, because the site could get a higher net potential return by doing so; the other securities were hedged with optimal collars. Below is a closer look at the optimal collar hedge for VXX.

As you can see in the section of the screen capture above (image via the Portfolio Armor iOS app), the cost of the put leg of the VXX collar was $22,790, or 18.04% of position value. However, if you look at the section of the screen capture below, you'll see that the cost of the put leg was more than offset by income of $25,705, or 20.34% of position value, from the short call leg.

So the net cost of this collar was negative, meaning the investor would have collected $2,915 in income when opening it. Note that, to be conservative, the cost here was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less (at some price between the bid and ask), and sell calls for more (again, at some price between the bid and the ask), so the actual cost of this hedge would likely have been less. The same is true of the other hedges in this portfolio, as they were calculated in a similarly conservative manner.

To be honest, I'm a little uncomfortable seeing VXX in this portfolio. It's not something I would have selected, given its terrible long-term return. But, in the worst case scenario, this VXX position won't be down more than 7.69%, after taking into account the negative cost of $2,915. Let's check back in six months and see how this portfolio has done.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.