“What if…?” is a question that pops up constantly, especially when it comes to investing. What if equities fall? What if bond yields rise? It’s sometimes useful to think of the converse: What if equities don’t fall?

Or what if they do decline, but it’s from a much higher level? But answering a question with a question—while useful in jarring oneself out of a particular perspective—isn’t all that comforting. What can be comforting is having a risk management program, which can help deal with the “what ifs” of life.

In this two-part blog series, I’ll discuss the building blocks for developing a program that’s designed to meet investors’ goals and views on risk—all while focusing on a very important theme: The need for balancing trade-offs between desired outcomes.

The process of building a risk management program

A risk management program is a process that involves a feedback loop: It starts with an evaluation of goals, identifies risks, designs a strategy for managing those risks, implements that strategy, and evaluates it in light of changing goals and risks. A good program adapts with changing conditions as well as the changing tools available for managing risk.

 

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Evaluate the assets and liabilities

The design process for a risk management program starts with understanding the investor’s goals. From my perspective on our Multi-Asset Solutions Team, it’s essential to define all risk in terms of the investor’s goal. When it’s time to make a portfolio change, the question must be asked: Would the change make it more or less likely that the investor will achieve those goals?

A key starting point is to evaluate all the sources and uses of funds (current and expected) along with the existing portfolio allocation. For individual investors, a common goal is having a comfortable retirement, and that means:

  • Making meaningful contributions to a retirement account
  • Allocating it appropriately
  • And then managing the allocation and distributions while in retirement

Most people plan to make small contributions over a long period, to fund larger distributions over a shorter timeframe.

Even this simple description of describing the sources and uses of funds can help illuminate some risks that require managing. For example, contributions to retirement plans come from a person’s wages, and wages typically rise faster than the consumer price index—therefore, inflation risk is at least partially managed by working. However, once a person enters retirement, the portfolio itself has to do the heavy-lifting of combatting inflation. That means inflation risk is typically more material in retirement than in the years of saving for retirement.

Let’s unpack this example some more. A person’s contributions depend on wages from an employer, and most workers possess skills that may be specialized for a particular type of job or industry. That means wage income is vulnerable to risks that are specific to an economy, an industry, and a specific firm. And this is where diversification can be very powerful: If a person works in the tech sector, that’s an important variable to consider when putting together a portfolio. In this scenario, the tech exposure in a person’s portfolio can amplify, rather than diversify, the tech exposure of the person’s employment.

This connection between a person’s profession and investments underscores why it’s so important to identify and balance the macroeconomic risks of a portfolio. One of the ways to do this is to identify the statistical relationship between asset returns and macroeconomic variables. These statistical relationships can change with time, valuations, and conditions, but they at least give a rough guide to the macroeconomic exposures and risks of various assets.

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Investors may have particular views or concerns about the macroeconomic drivers of returns, including concerns about growth, real interest rates, inflation, and valuations. By identifying the sensitivities of the sources of funds, uses of funds, and the portfolio allocation to the macroeconomic drivers of returns, investors can at least be aware of the implicit or explicit bets they may be making with their portfolios. Being aware of a risk is an important part of managing it.

Different solutions for different risks 

If an investor wants risk protection, a key question to ask is, “From what are they seeking protection?” If the investor is seeking protection from simple market variability, the solution will be different than if the investor is seeking protection from an increase in inflation, a decrease in growth, or some catastrophic event. Different concerns merit different solutions. Many risks can be managed through diversification, a “soft form” of risk management. This works well when correlations are predictable, but when market conditions deteriorate, diversification tends to become less effective. In that case, investors need to consider looking at quantitative and qualitative techniques, sometimes employing derivatives. For extreme events, tail-risk strategies—such as option strategies—can be useful.

Any changes to a portfolio should be made in light of an investor’s specific goals; it’s not appropriate to make incremental changes if the changes make it materially less likely that the investor will achieve his or her goals. When it comes to any specific risk management strategy, investors need to recognize there are always tradeoffs.

There is no such thing as a free lunch in risk management

All risk management strategies are subject to a trilemma, a term that refers to a situation where a person seeks three things, but while getting closer to two of them, the third thing gets further and further away. When it comes to designing and implementing a risk management strategy, there are three things to seek:

  • Minimizing costs: Cost is one of the first considerations of risk management. Costs can be explicit or implicit. An explicit cost is when money is expended to provide the protection, which could reduce the expected return. An implicit cost is the price of giving up gains. Often, to get downside protection, upside potential is also sacrificed.
  • Maximizing consistency: Consistency is whether a particular risk management strategy can regularly and predictably protect on the downside. This can be measured by the strategy’s success rate in providing gains, when the underlying portfolio experiences losses.
  • Maximizing reactivity: Reactivity refers to the risk management strategy’s sensitivity to downside price movements. While consistency measures the success rate, or how frequently a strategy can provide protection, reactivity measures the extent of the protection provided.

However, an investor cannot simultaneously do those three things; instead the risk management strategy needs to balance some key trade-offs.

 

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Practical implementation

The objective of a risk management program is not to eliminate risk. By eliminating risk, investors should not expect to earn more than the risk-free return. Rather, the point is to manage the risks, and build portfolios that behave in ways investors expect. In the second and final blog post in this series, I will discuss ways to implement a risk management program, while setting the framework in place for evaluating the program over time, to help ensure it can continue to address investors’ needs.

 

Dr. Brian Jacobsen, CFA, CFP, is a Senior Investment Strategist with the Wells Fargo Asset Management Multi-Asset Solutions Team.

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