Exiting a rocky market rather than sticking it out can often lead to worse results for nervous investors, says Jack Delany, quantitative portfolio manager with the multi-asset team at Dublin-based Irish Life Investment Managers.

Delany said the temptation to cut and run can be strong, but markets favour those who dare to stay invested.

“It seems like a really natural response when your portfolio loses value to reduce risk and wait for better times,” he said. “But we know that over the long term, this can be a very costly strategy.”

Secret weapon

Speaking on the latest episode of the Soundbites podcast, Delany said investors dig themselves into a hole when they de-risk their portfolio at a cost, and then fail to reap benefits during the subsequent recovery. Rather than pull money out of the market, he suggests investors use risk-mitigation strategies, which he described as the smart investor’s secret weapon.

“These can be either explicit risk-reduction strategies that purchase protection against an underlying asset, or implicit risk-reduction strategies that allocate to more defensive exposures or that dynamically manage exposures at different points in the cycle,” he said. “Both of these approaches, though, can be combined to manage losses and deliver a smoother return profile for investors.”

The most common strategy is also the most powerful: diversification across equities, bond classes, regions and currencies.

Beyond straightforward diversification, he employs other tactics that deliver the potential for both protection in down markets and participation in up markets.

Several strategies

“Examples of useful strategies includes collar option strategies, where we use put options to protect against losses but still leave room for some upside participation; low-volatility equity strategies — long-only equity strategies — that target more defensive, lower-beta, lower-volatility allocations; and finally, tactical allocation strategies,” Delany said. These strategies allow investors “to systematically reduce their equity allocation when the outlook is not favourable or increase it when the outlook improves.”

The most successful investors wouldn’t eliminate systematic risk from their portfolio, even if they could, he said.

“The only way to completely insulate a portfolio from systematic risk is to invest fully in cash, and this is a strategy that simply won’t generate the returns, over the long term, that most investors are looking for,” he said. “Taking a risk is a necessity when it comes to generating returns.”

The trick, he added, is to invest intelligently.

“Robust asset allocation, underpinned by both qualitative and quantitative analysis, goes a long way to deliver that smoother return profile that investors want.”

Delany said the key to the asset allocation process is considering the objective risk constraints of the client and tailoring the design of the portfolio accordingly.

Optimizing the portfolio

“The considerations here can include risk and return, but also liquidity constraints, income requirements, whether the portfolio is being built for pre- or post-retirement investors and so on,” Delany said. “Once these points have been established, we utilize an asset allocation framework that focuses on positioning portfolios to deliver over the long term.”

Emotions will still play a role when markets start to fluctuate, but there are several ways to tame them.

“The key step is education, ensuring that investors are invested in portfolios suited to their risk appetite and that they fully understand the loss potential of their investments,” he said. “Advisors have a key role to play here, sitting down with the client and outlining these considerations.”

He said getting comfortable with market volatility risk and understanding risk tolerances will help reduce “sub-optimal emotional responses” when losses occur.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.

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