Over the past few weeks, we’ve explored the key issues around the importance of mitigating risk in clients’ investment portfolios, the inherent limitations of some of the more common and traditional methods of reducing portfolio risk, and the most important characteristics to look for in an effective risk mitigation strategy.
Here are the key takeaways we’ve learned on that journey:
1. Investors can benefit greatly by addressing three main investment risks.
There are three key risks that a risk mitigation strategy should be designed to address so that investors can successfully pursue their financial goals according to their wishes.
- • Losing significant amounts of wealth. Drawdown—the absolute dollar losses in a portfolio—is one of the most dangerous risks many investors face. That’s especially true for investors nearing the time when they’ll need to start funding a goal using money from their investment accounts. These “protect-stage” clients often don’t have enough time to recover from big portfolio losses.
- • Missing out on upside growth. Most investors—even those who are closing in on their goals—may still need portfolio growth to help them reach the finish line. Missing out on investment gains by investing too conservatively or by being out of the markets during big upswings, for example, can prevent clients from achieving their most important objectives. (Lack of adequate portfolio growth could also spell trouble for you, as unhappy clients potentially begin to doubt the value you bring to them.)
- • Making costly, emotion-driven investment decisions. Investors’ emotions and behaviors can derail their financial prospects if they let their fear or greed override clear-headed thinking. Emotional reactions to big market gyrations or scary media headlines can lead to problematic behaviors—such as buying stocks at their peak prices then selling them after they’ve fallen (thereby turning a paper loss into a realized one). Likewise, investors often are slow to get back into the markets after they suffer a painful loss–causing them to remain overly conservative and potentially miss out on some gains when markets recover. These reactions can harm just about any investor’s prospects—even ones who are decades away from needing to fund a goal.
2. Risk reduction strategies too often have problems. Some of the most commonly used risk reduction methods may contain fundamental flaws that make them less-than-ideal for investors (and advisors) trying to address the three main investment risks. For example:
- • Diversification requires future relationships (such as correlation, covariance, distribution of returns) between different investment categories to be both known and stable. But those future relationships are simply unknowable—and tend to become quite unstable during market declines, right when investors look to diversification for shelter from the storm.
- • Market timing strategies mistakenly assume that asset prices’ past behavior provides reliable information about what they’ll do next. But financial markets’ rules aren’t always stable or consistent. A timing strategy without the flexibility to adapt to changing market dynamics can’t help investors sidestep losses—or shift them back in time to capture gains—consistently over long periods.
- • Portfolio insurance tends to fail exactly when protect-stage investors need it most—such as when prices nosedive rapidly. That’s because this risk reduction method doesn’t take into account issues such as large gaps in securities’ prices that can occur from moment to moment, or liquidity crunches during periods of market stress that reduce the insurance’s ability to de-risk a portfolio.
3. A risk mitigation strategy should possess specific traits that can maximize its effectiveness at reducing investors’ exposure to the three key risks. Our empirical research and experience point to six key portfolio risk mitigation characteristics that appear to be most effective:
• Use liquid securities to de-risk the portfolio. Treasuries, for example, can help clients avoid liquidity problems that can sink other risk reduction strategies.
• Focus on avoiding catastrophic losses. By taking de-risking action only when a portfolio’s specific and well-defined loss tolerance threshold is threatened, investors can avoid overreacting to small market moves that are temporary.
• Employ volatility forecasting to guide de-risking and re-risking decisions. Basing decisions to exit a market (and later re-enter it) on expected future volatility levels can help avoid being repeatedly whipsawed—the costly cycle of repeatedly buying in at a high point and selling at a low point.
• Default to a fully invested position. A risk reduction strategy should be fully invested in equities as its starting point or default position, so investors can fully participate in rising markets (which occur the majority of the time) and potentially generate higher returns.
• Protect portfolio gains as they occur. A portfolio’s loss tolerance threshold should rise along with the value of that portfolio. That way, a risk mitigation strategy may be able to help protect a portfolio’s rising value over time.
• Use a clear, rules-based approach to de-risking and re-risking decisions. A rules-based decision-making system, implemented consistently, can help stop investors from jumping in and out of markets based on fear. But such a system also has to make sense. If a risk reduction strategy is clear and transparent, clients are more likely to have confidence in it—and you–when markets are tough and emotions run high.
The upshot: Clients at all stages of their investment journey can potentially benefit from having a risk reduction strategy in place.
That said, the strategy should be designed to address the biggest threats clients face in pursuit of their most important financial goals. A strategy that is fundamentally flawed simply won’t be effective enough to get the job done.
Determine if your current approach to risk mitigation is doing all it should to address the major risks—or if it’s time to consider using a new approach that will maximize your clients’ ability to grow and protect their wealth, and remain confident on their goals-based investment journey.
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