Strategies and techniques to assess and manage risk in your investment portfolio
Friday, Feb 2, 2024
The Premise.
“You read that the market’s have been gaining significant momentum in the past couple of years. Everyone has been talking about it. Especially in the past couple of months, this has been the major conversation all over the media. The stock market as a whole has reached the peak, a high that the world has never witnessed. Every stock is up a significant value and all the old-time portfolios are very green.
You decide that this is an excellent opportunity to invest as what other technical indicator or expert advise do you need? The rise of the markets is so evident even from a cursory review of the markets. The sentiment towards it is extremely positive as well.
So you invest.
The investment you made, initially seems to be fluctuating in the similar buy in range, but then as weeks and months go by, you start to realize that it’s not at all what you were expecting from it. When you decided to invest, the stats you were tempted by to do so were double digit increment percentages.
Your new portfolio takes a slight hit and derails from a growth trajectory. You decide to investigate. You start tuning into discussions regarding specifics of the stock that you’re invested in. You realize that something doesn’t feel right as you listen to skeptics talk about the stock markets as overvalued. It even instills a sense of fear in you. You follow the markets everyday and stare at your portfolio. When it goes a bit down, you’re hoping these are just fluctuations, and that it’ll be back up. When it stays low for a significant time, you’re questioning and regretting your decision to have made this investment and are praying for it to just come back to the same price you bought for and hit breakeven, so that you can exit with you hard-earned capital. But this is far from the reality you’re about to witness.
And one morning, all the global market indices are red, and this is the beginning of the downfall. The markets crash.”
Now that’s a scary scenario but there are methods and strategies you can use to stay on the safer side. In this article, let us understand how the parameter “risk” fits into the portfolio construction and investments paradigm and the ways in which you can minimize risk.
Introduction
Portfolio construction is a challenging endeavor to say the least. Even though it seems that you just got to buy low and sell high, knowing what exactly to buy and when, is a tough nut to crack. Most times, going with the trend is a good idea, on the contrary, during the beginning of a market crash, this would be the worst idea as you would be stuck or simply would get wiped out with all other portfolios. Such events have only occurred a handful of times, but there’s lots of learning that can come from it.
Crashes are attributed to loss of wealth but if we look at history, the biggest gains ever made, largest financial bets taken, and the creation of Billionaires, have occurred during such times. It’s contradictory but true. Opportunistic investors don’t rely on a linear approach based on time and growth in making financial commitments but rather study the inherent value associated with businesses that make up the market. By tracking the macroeconomic trends and metrics, assessing the sentiments associated, investigating the flow of funds between sectors, such investors mitigate the risk associated with their investments. Rather than trying to gain the most from the markets, they are in the game of optimizing the portfolio for minimal risk while calibrating it towards steady growth.
The Definition.
Let us start by trying to understand the fundamentals of risk management. Risk management is a process by which an investor mitigates risk and optimizes the portfolio based on risk or return. In the context of investment portfolios, risk mitigation is considered a critical aspect of successful wealth management. In the broad sense, risk mitigation involves identifying and mitigating negative impact on a financial portfolio due to uncertain extrinsic factors. From the investor POV, it helps in optimizing return while mimizing risk and in times of high-volatility market circumstances and unexpected economic shocks, it enables portfolio protection. Protected investments directly translates to higher investor confidence and can help achieving long-term financial stability.
Assessing Risking Ability.
Know What You Want.
How willing you are to take on financial risk entirely depends on what your goals are. In order to form an all encompassing strategy, the potential exit outcome needs to be clear. When will you need the money? That’s something that needs to be evaluated and assessed upfront.
What Risk Is Too Much?
The general trend goes like, younger investor - bigger target, correlates with high-risk territory and older investor - consistent low returns, correlates with low-risk territory. Although that’s the trend, that isn’t true in all cases. Basically, what is the degree of variability in returns that you’ll be able to withstand? That’s the primary decider.
Once an investor is self-aware;
- Aligning the portfolio that is balanced with respect to the risk and returns is possible.
- Making decisions for diversification which is a core risk-mitigation strategy could be customized.
- Personalized investment strategies keeping in mind the goals and targets of the investor can be crafted.
- The growth prospects and the portfolio stability can be optimized.
Willingness to Risk It.
Self-awareness play in constructing a well-balanced portfolio.
Let’s go through the mindset of two investors; Alice and Bob. Both of them have $100,000 to invest for their retirement.
Alice is a pretty conservative investor who wants to preserve her principal and avoid losses at all cost. She’s willing to accept low returns for a secure and stable portfolio. This is how she might allocate her portfolio:
- 60% in bonds, such as government and corporate bonds, that pay regular interest and have low default risk.
- 20% in stocks, such as blue-chip and dividend-paying stocks, that have steady earnings and growth potential.
- 10% in cash and cash equivalents, such as money market funds and certificates of deposit, that provide liquidity and safety.
- 10% in alternative investments, such as real estate and commodities, that offer diversification and hedge against inflation.
Alice expects to earn an average annual return of 5% from her portfolio, with a standard deviation of 10%. She is comfortable with the level of risk that she’s taken and the volatility within her portfolio, and she does not react to short-term market fluctuations as her portfolio is optimized for stability. She plans to rebalance her portfolio once a year to maintain her target allocation.
Now let’s see about Bob.
Bob is an aggressive investor who wants to maximize his returns by taking on high levels of risk. As he is confident in his ability to read the market sentiment, assess and calibrate his portfolio for changing market conditions, and recover from losses that his portfolio might be subjected to, here’s how he allocates his portfolio.
- 80% in stocks, such as growth and value stocks, that have high earnings and growth potential.
- 10% in bonds, such as high-yield and emerging market bonds, that pay higher interest but have higher default risk.
- 5% in cash and cash equivalents, such as money market funds and certificates of deposit, that provide liquidity and safety.
- 5% in alternative investments, such as hedge funds and private equity, that offer high returns but have high fees and low liquidity.
He expects to earn an average annual return of 10% from his portfolio, with a standard deviation of 20%. He is aware of the level of risk he’s taken to achieve the aimed returns. He understand the volatility in his portfolio, and is willing to accept the possibility of large losses. His plan is to rebalance his portfolio quarterly and keeps reviewing his investments seriously each week for assessing impact from present market conditions.
Methods For Quantifying Investors’ Risk Tolerance
If you look at any book that finance students study on their way to becoming experts in the Finance domain, there are three primary fundamental theoretical models that every academic lecture on investment management relies on. These are Efficient Frontier, the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH). Built on their premise there are further advanced extended variations as well.
Let’s review the fundamentals of each of these and review what the theory suggests when talking about risk.
Modern Portfolio Theory
If you want to mathematically assess the perfect financial portfolio in terms of fidelity of risk-return tradeoff, you will land upon the Modern Portfolio Theory which was introduced by Harry Markowitz in 1952. The expected return from a portfolio and the corresponding standard deviation can be calculated using the weights of individual assets in the portfolio, their expected returns, and the covariance matrix. As each of the assets and asset classes has their own set of weights in terms of risk, the global average of the risk can be minimized by careful allocation of diversified assets. Efficient frontier visually depicted on a chart with expected return on the y-axis and risk (standard deviation) on the x-axis, showing the trade-off between risk and return. Optimal portfolios are those that exist above the Capital Market Line
Capital Asset Pricing Model:
Developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s, CAPM considers systematic risk in the broader context of investing. CAPM establishes a clear relationship between the expected return on an investment and its systematic risk. The aim of CAPM is to come up to an exact solution for risk calculation.
First, there's the risk-free rate, which represents the return on a completely risk-free asset like a government bond. The market risk premium, the additional return expected for taking on market risk, is also factored in. By combining these elements, CAPM provides a straightforward equation: expected return equals the risk-free rate plus beta multiplied by the market risk premium.
E(Ri ) = Rf +βi ( E(R m) − Rf )
In simpler terms, it helps investors estimate how much return they should expect based on the level of risk associated with a particular investment compared to the overall market.
E(Ri) is the expected return on the investment
Rf is the risk-free rate
βi is measure of an investment’s systematic risk.
E(R m ) is the expected return of the market portfolio
E(Rm)−Rf) is the market risk premium. It indicates the additional return that can be expected for taking on market risk.
Efficient Market Hypothesis:
Developed notably by economists Eugene Fama, Paul Samuelson, EMH is a theory that financial markets are informationally efficient. The anticipated notion is that the correlation between the publicly available information and the value of an asset in the financial markets are entirely reflected. This hypothesis was developed back in the 1960s and 1970s. Since then, it’s known that the markets aren’t really entirely efficient. Many behavioral biases of investors come into play, altering and contributing toward irrational fluctuations and compacting market dynamics. A strong form correlation would imply that even insider information wouldn’t really matter as the assets already inherit the maximum value.
Sector Rotation
Sector rotation is a strategy that involves sector based investing and portfolio calibration based on economic cycles. Switching between asset classes at a regular time cycle is the premise of sector rotation. A study that examined the performance of different sector rotation strategies for the US and European market from 1999 to 2019 found that sector rotation strategies tend to produce returns above the average benchmark, both during contractionary and expansionary monetary policy regimes
Let’s take a realistic extreme global scenario to understand the fundamentals of how and why this works.
Consider the market dynamics and behavior during times of war. If a nation is war-struck, from a rational POV, the sectors that would perform well are defense, technology, and industrials, as well as those that provide essential goods and services, such as health care, consumer staples, and utilities, The government is forced to spend and create initiatives to maximize efficiency among these sectors. Moreover, essentials, health care, consumer staples and utilities are resilient to economic shocks.
If you look on the contrary, sectors that are sensitive to consumer sentiments, travel, financial institutions, and transportation, any company that would be impacted by global logistic issues, all struggle to perform well and sustain during extended wartime.
Let’s take a look at some of the small cases offered by Green Portfolio. The platform is known for its creative take on professionally created portfolios based on different themes, strategies, and objectives.
One of the small cases that follows the sector rotation strategy is the Smart Index Advantage small case. It invests in the top 12-15 NIFTY stocks that is aimed specifically at outperforming. Dynamic adjustments are made to the weights of the stocks based on relative performance and anticipated market conditions. It has delivered a 4-year CAGR of 28.77%, beating the NIFTY 50 index by a wide margin.
Another small case that applies the sector rotation principle is the Rising Responsibly: Green ESG small case. It focuses on environmental, social, and governance (ESG) factors for long-term sustainable wealth creation. This small case has achieved a 2-year CAGR of 25.55%, outperforming the NIFTY ESG index.
Behavioral Biases
Humans aren’t as rational as one expects them to be. This is especially true when people make financial decisions. Psychologically, people seem to be preprogrammed to have intrinsic biases.
While making investment decisions, there are several biases that can be seen with the general populous. Here are a few top ones that you need to avoid.
Availability Bias:
Any information that’s readily available in the mind, factors heavily into the decision one makes. Easier the information retrieval, quicker the biased decision. If you generally question randomly about the best performing mutual funds, people are likely to mention the names of ones that they’ve heard of. If people have personally experienced something, it’s likely that they conflate that experience with reality. If people can resonate with something, this also plays a crucial role in making an elementary biased decision.
Representativeness Bias:
When considering factors, people don’t seem to consider the factual dataset at its entirety. Rather than considering pure probability, people make irrational judgements based purely on what they find has the potential to be the right choice. By sticking to the generic notions, stereotypes, and familiar cases, a person doesn’t thoroughly investigate a case but draws an irrational conclusion.
Herding Bias:
It’s exactly what you think of when you read. Herd bias hypothesizes that people who communicate with each other tend to follow each other. When you make a decision without rationally justifying it to yourself, but use somebody you know, a group of people you follow or an institution that you’re associated with to justify a decision, is termed herding bias. Herding actually explains why speculative bubbles form in finance markets. If people are bullish, they are ready to buy even though the value is already at an unjustifiable high, and when sellers only want to sell high, together, the prices of
Overoptimism Bias:
This occurs when people have an illusion of knowledge and overestimate their own capabilities. Overoptimism endangers your capital. It’s highly essential that you invest responsibly.
Overconfidence Bias:
When people believe that their thoughts and opinion on a matter is objectively better that the true fact. Overoptimism is about intrinsic personal belief about self-traits but confidence is about objective facts.
Anchoring Bias:
Humans rely a lot on the first piece of information they receive when making decisions. This cognitive shortcut is known as anchoring bias. You can influence people’s decision by feeding them with meaningless data just prior to making a decision.
The Bottom line.
Consistent investing is one of the medium for attaining financial goals through systematic investing. Warren Buffet is known for his disciplined investment approach. Despite market conditions, through Berkshire Hathaway, adheres to value investing. Essentially, performing fundamental analysis and buying stocks of companies that are undervalued. He often holds his investments for decades.
When the markets were extremely shaken up, Buffett recognized the intrinsic value of Coca-Cola, and invested heavily in the company. He bought more than $1 billion in shares which is equivalent to 6.2% of the company at that time. Not just Warren Buffet, there are other investors who vulture in on opportunities. In 2007, investor John Paulson made nearly $4 billion by using credit default swaps to bet against the U.S. housing market. In 2009, during the financial crisis, David Tepper's hedge fund, Appaloosa Management, invested heavily in distressed financial stocks, including Bank of America and Citigroup. These investments paid off big time when the market recovered.
Contrarian investing pays off bigtime, when done right.
Avoiding panic and strategically optimizing your portfolio that suits your risk tolerance ensures that you do not panic during market shock circumstances. Doing diligent research is critical. If you notice that you don’t have enough time to do so, Green Portfolio has crafted small cases that can help you achieve your investment goals.
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