Risk management strategy needs to balance three key trade-offs. Multi-asset class strategist Dr. Brian Jacobsen explains as he discusses strategy design.
Jon Lagerstedt: In this third installment discussing “Building blocks of a risk management program,” we’re talking designing the strategy and trade-offs to consider when you balance all of these things together. I’m Jon Lagerstedt, and this is The Essential Practice podcast.
With us again is Dr. Brian Jacobsen, Senior Investment Strategist with the Wells Fargo Asset Management Multi-Asset Solutions Team. Brian, welcome once again.
Brian Jacobsen: Thanks for having me back.
Jon: In fact, it’s kind of amazing, Brian, when we did the first installment of this mini-series I was wishing you a “Happy New Year,” and now we’re two months into 2018 already. Time is fleeting quickly, which really stresses the importance of having a risk management strategy in place.
Brian: It sure does, especially considering the sudden pick up in volatility that we saw. I think that caught a lot of people by surprise. You went from incredibly low volatility to a disintegration of that low-volatility trade that a lot of people had on. And we suddenly get a market correction. And right now, as we speak at least, we’re going through a market bounce back. So yes, risk management should be top-of-mind for everybody.
Jon: Well I’ll encourage our listeners to go back and listen to the first two episodes in the series, episodes 402 and 403, the first two of our five building blocks which were evaluating goals and identifying risks. You might also consider visiting our AdvantageVoice® blog to read a couple articles that Brian wrote recently back in January called, “Tackling what ifs…” But today we’re talking about strategy design, and Brian, you wrote: “There’s no free lunch.” How does that apply here?
Brian: Well, hopefully everybody has heard there being “no free lunch” in just about everything—somebody offers you a free vacation, right, often times it’s not really free because there’s an opportunity cost involved in you using your time to go on that vacation.
For us, we think about a trade-off amongst what we call a trilemma—consistency, reactivity, and the cost associated with any given risk management strategy.
Jon: And if we could, let’s go through each of those, and first, minimizing cost.
Brian: Sure. And actually I like to say that the goal really shouldn’t just be to minimize cost. Cost is one dimension of the problem. If you think about the cost of, let’s say, different options strategies you can have, right? You pay a premium, you pay something up front, and you have to ask yourself, “Well, is it worth it?” And then also, “Are there other hidden costs associated with this?” And that’s why it’s important to include both the explicit costs—the dollar and cents that you pay—but then the implicit costs as far as maybe the complexity of it as far as managing the program. And then also, what do you give up?
Brian: And I think that with some downside protection strategies that some people try to implement, they just focus on what the benefit is here. I get this downside protection, but you should also consider what do you give up on the upside as well. Because, yes, it might give you comfort to have that downside protection, but it could come at a pretty steep cost if it means that you’re not participating fully in upside market gains.
Jon: Excellent point. The second key you mention, Brian, is about maximizing consistency. Can you explain what that is?
Brian: Yes. So one way to think about it is almost like a baseball analogy. What’s your batting average? Are you consistently hitting the ball? Are you consistently getting on base? It doesn’t mean that you’re always hitting a home run. Right?
So the consistency part is, does it regularly and predictably actually provide the type of protection you’re looking for against the risks that you’ve identified.
Jon: The third of the key things you suggest investors should keep an eye on is maximizing reactivity.
Brian: So the reactivity part is more like—just to maybe stretch out the baseball analogy a little bit—is: Are they a home run hitter? Or are they always only just getting to first base?
So reactivity has to do with the strategy’s sensitivity to downside price movement. It’s about the magnitude of the protection that it actually provides.
Jon: Brian, do you think you could go a little bit deeper on that? When you talking about the magnitude, is there an example you can provide us that would help illustrate what that magnitude could be?
Brian: Sure. So one of the ways I like to think about it is if I want to add a little bit of downside protection to a portfolio, maybe what I’ll do is I’ll add a defensive sleeve to my portfolio—you know, like gold, the U.S. dollar, and also the Japanese yen is often times viewed as a safe-haven play. While yes, they might sort of move in the way that you want them to, they don’t always move in the magnitude, or the amount that you need them to, to provide the coverage you really want there.
Jon: Excellent, thank you. I guess the last of this series of questions is: What’s a realistic expectation when try to balance all of these things together?
Brian: Well, I think the most realistic thing is to know that you’re not going to get going to get all three of them at the same time. So I think it’s about understanding that there are trade-offs, and then in the context of the problem that you’re trying to solve, make sure you pick the right trade-off.
Jon: You know Brian, we’ve got two more building blocks to discuss after this that cover practical implementation and evaluating the program, but we’d welcome a parting thought, perhaps how your team manages the trilemma dilemma.
Brian: Sure. So what we do is, it really comes down to developing a risk management program that the client is comfortable with. Because, without the client being really comfortable with it and understanding it, you could have the best risk management program in place, but if they abandon it when they most need it, then it’s really done you no good.
Jon: Brian, that’s going to be all for today’s episode. I want to thank you, and we certainly look forward to look forward to the next two installments on the topic.
Brian: Yes. Thanks for having me.
Jon: Absolutely. And as a reminder, you can get more from Brian on our companion podcast On the Trading Desk® and on our blog AdvantageVoice®. Until next time, I’m Jon Lagerstedt, and this is The Essential Practice podcast.