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.
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.
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.
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.
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.
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.
