Six Components for an Effective Risk Mitigation Strategy
As clients close in on their goals, they need tools and strategies to mitigate the specific investment risks they now face and start protecting their assets. Those risks may include losing significant amounts of wealth and missing out on potential investment gains, among others. To read Click Here.
Trouble is, many of the most traditional and commonly-used risk reduction strategies may have problematic design flaws, to read Click Here, that prevent them from addressing those and other key risks.
To help “protect-stage” clients maximize their probability of reaching their goals, it’s crucial to identify the components that make up an effective risk mitigation strategy—the features that can work to reduce the major risks your clients face.
Armed with these insights, you can go out and find the risk reduction tools that will empower you to put your clients in a position to achieve their most important goals.
The three risk-reduction “should haves”
First, it’s important to remember that a risk mitigation strategy should deliver three key results to investors in order to considered effective:
1. Mitigate large losses in the value of their portfolios. Protect-stage investors may not have the time needed to recover from major drawdowns.
2. Capture upside investment gains to generate continued portfolio growth. Investors nearing a goal still likely require additional asset growth from equities to help them across the finish line—and investment gains are a beneficial risk management tool, as well.
3. Improve investor discipline by reducing or eliminating emotional decision-making about their portfolios. Allowing fear to drive investment decisions during challenging market environments can derail investors’ plans and jeopardize their chances of being able to pay for their financial goals.
Six keys to pursuing results
To achieve all of those results, a risk mitigation strategy should have a number of key traits and take certain steps that can maximize its probability of success on behalf of investors.
Based on our research, experience and efforts, we believe these are six of the most important qualities to expect and demand from a risk reduction strategy:
1. Use liquid securities as the de-risking vehicle. A risk reduction strategy that uses highly liquid assets (such as Treasury securities) as its de-risking vehicle can sidestep major losses more effectively than one based on more esoteric vehicles like derivatives or inverse products such as inverse ETF and ETNs. As noted in The Pros and Cons of Four Risk Mitigation Strategies, to read Click Here, those types of strategies often experience major liquidity crunches that can fuel intense selling pressure during down markets—failing exactly when investors most need them to kick in.
In contrast, Treasury securities—already the most liquid securities in the world—have demonstrated that they can become even more liquid during periods of market stress, helping to avoid liquidity problems that can sink other risk reduction strategies.
2. Focus on mitigating catastrophic losses. Smart risk reduction allows for “normal” levels of portfolio volatility and losses before any de-risking kicks in. Otherwise, it’s too easy to overreact to every market movement—which can quickly lead to selling stocks when they hit a low point, buying them back when they hit a high and repeating the process. One way to combat that is to focus on helping investors attempt to avoid significant, catastrophic portfolio losses that can potentially wreck their future prospects. This is done by taking de-risking action only when a portfolio’s specific and well-defined loss tolerance threshold is threatened.
3. Employ volatility forecasting to avoid being whipsawed. The cost of a risk reduction strategy is best defined by the number of times it gets whipsawed—that is, selling out of a risk asset after it has fallen to a recent low, and buying it back after it has risen back to a recent high. Do that often enough and the strategy’s cost outweighs its benefits.
A risk mitigation strategy can minimize that cost by adjusting its exit and re-entry points using volatility forecasting. For example, a forecast for high volatility increases the likelihood of buying low and selling high. To avoid that negative outcome, a strategy can widen its buy/sell thresholds. Conversely, a low volatility forecast can enable a risk reduction strategy to shrink those parameters.
Important: Volatility forecasting is different from return forecasting or price forecasting that attempts to predict if an index’s or security’s value will move higher or lower in an effort to “sell the top” or “buy the bottom.” That type of timing strategy has been repeatedly shown to be virtually impossible to implement consistently over long time horizons.
4. Default to a fully-invested position. A risk reduction strategy should be fully invested in equities as its starting point or default position, so it can fully participate in stock market gains when they are there for the taking. One reason: Since 1928, the S&P 500 index has posted a positive return during 68.7% of all quarterly periods, and during 74.3% of all one-year periods. By fully participating in markets such as 2013 (+32%) and 2017 (+22%), portfolios can potentially generate significantly more wealth than if their de-risking feature was always “on.” Being fully invested also removes the need to guess if markets will go up or down—which comes with the extremely high cost of missed gains if those guesses are wrong.
5. Protect portfolio gains as they occur. Effective risk mitigation should be designed to increase a portfolio’s maximum loss tolerance threshold once that portfolio’s value rises by a certain amount (such as 3% or 5%, for example).
To understand why, consider a simple example of a $100 stock portfolio using a risk reduction strategy that allows for a 15% maximum loss in value—meaning its loss threshold is $85. If that portfolio’s value rises to $105, the threshold should be increased to around $90 instead of staying static at $85. ($105 – 15% = approximately $90). The same step would be taken once that portfolio hit $110 and so on. In this way, a risk mitigation strategy may be able to help protect a portfolio’s rising value over time.
6. Apply an understandable and consistent rules-based approach to risk management decisions. Most, if not all, risk mitigation strategies set up rules and parameters that guide their decisions about when to de-risk and re-risk. However, the more consistent and rigorous those rules are, the more likely investors and advisors will be to stick to the strategy instead of abandoning it at the wrong moments.
That said, a rules-based process alone isn’t sufficient. Transparency and understanding about a strategy’s rules are crucial components of effective risk mitigation, especially when it comes to instilling discipline and helping investors keep a cool head during stressful markets. Ultimately it boils down to a simple concept: If a risk reduction strategy makes sense to you and you can see it working on your behalf, you’re more likely to have confidence in it and stick with it—especially when market risks are high—than you would with a strategy that is overly complex, opaque or cloaked in secrecy.
While there’s no shortage of risk reduction strategy and methods, they’re not all created equal. By understanding what works and what doesn’t when it comes to helping clients best manage portfolio risk, you can take steps to determine if your current approach to risk mitigation is doing all it should—or if it’s time to consider using a new approach that will maximize your clients’ ability to grow and protect their wealth and enjoy the experience along the way.
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