Chapter 22

Managing Risks

Controlling risks along the journey

‘There are old pilots, and there are bold pilots, but there are no old, bold pilots.’

E. Hamilton Lee

The core of investing is bearing and managing risks. You need risk to generate returns. But you need to control it to limit losses. In particular, you must mitigate the risk of ruin – losing so much that recovering the losses is unlikely, for example, because of insufficient time.

Managing risks involves two separate activities: risk measurement and risk management. Risk measurement quantifies risks. Risk management is deciding which risks to take, which risks to mitigate and how to do so.

In this chapter we review some risk measurement and management techniques. We keep it simple, assuming you do not have access to sophisticated risk management tools.

Risk measurement

Volatility

The easiest risk measurement is calculating portfolio volatility. Use your risk capital market assumptions (CMAs), applying them to your SAA (using SAA weights and indices representing asset classes), as long as your portfolio does not deviate significantly from it. To be precise, use the portfolio’s weights to funds, their volatilities and your correlation CMAs amongst assets to calculate portfolio volatility. However, sourcing all required data might be difficult. Some online platforms calculate your portfolio volatility.

Translate volatility to downside risk, linking it with your risk tolerance. Assume that in 19 of 20 years return will not be worse than two standard deviations below the mean, in particular when holding a multi-asset, well diversified portfolio.

Stress testing

Stress testing is a simulation technique measuring how a portfolio should perform under different situations.

Historic stress testing takes the returns of assets during a crisis (such as the 2000 technology bubble burst or the 2008 crisis), applies them to your asset allocation and calculates its hypothetical performance.

The advantages of historic stress testing are that it considers actual historic events (no need to imagine anything), it accounts for correlations amongst assets and it is simple. The disadvantage is that it assumes history repeats itself.

Instead of historic stress testing, you can hypothetically push assets, calculating how asset allocation would react (such as pushing equities down 20%). However, you need to assume how other assets in your portfolio, such as gilts, would perform, considering correlations amongst assets.¹

For example, your asset allocation is 50% UK equities, 40% gilts and 10% cash. You want to understand how it would have performed during some crises. Table 22.1 shows the results.

Table 22.1 Historic and hypothetical stress testing

Source: Bloomberg, FTSE 100 Index, iBoxx £ Gilts Index, UK Cash LIBOR TR 1 Month Index. Based on monthly total returns, measured in £

Scenario analysis

Scenario analysis imagines a number of potential alternative futures with different outcomes. Each scenario estimates asset returns. Assign probabilities to scenarios (base case, upside surprise and downside surprise) trying to position your portfolio to perform reasonably well under different possible events, not a single one.

The trick is you need creativity when thinking about scenarios.

Risk management

There are four risk management techniques:

1. Diversification.
2. Hedging.
3. Insurance.
4. Active management.

Diversification is a proven way to reduce idiosyncratic risk, leaving your portfolio with market risk. It needs to be done properly, ensuring you diversify across imperfectly correlated assets. It should be dynamic since assets’ characteristics and correlations change over time.

Hedging is reducing risk of an asset by taking an opposite position in a similar or highly correlated asset. When the first asset falls, the hedging position should appreciate, offsetting some losses.

Hedging is normally done when you do not want to sell the hedged asset due to transaction costs, you are unable to sell it, you do not want to sell it because risks are short-lived or you want to remove exposure to an unrewarded or specific risk.

For example, you hold a global equity fund, with a large exposure to the US dollar (the US equity market makes about 50% of global equities). You think the British pound is likely to appreciate against the dollar. You hedge by buying a hedged share class or by selling dollars and buying pounds with a currency forward.

Insurance is a financial instrument that should generate a payoff when other assets fall. Insurance costs a fee (premium). If the other assets do not fall, you still pay it. If the assets fall, you gain.

For example, put options on equity indices is a type of insurance. You pay a premium. If equity markets fall, the value of your options can appreciate. If equity markets do not fall, the premium is lost. However, with equity exposure elsewhere, the portfolio can still generate positive returns.

Insurance’s objective is limiting the downside, not enhancing returns. You buy fire insurance on your house, hoping never to use it. When buying insurance, prepare a budget of how much you are willing to spend on insuring your portfolio. Insurance costs can haemorrhage performance – keep an eye on spendings.

Options cost more when volatility is high and less when it is low. Try buying options when volatility is low, when demand for insurance is weak, as markets are calm. However, when markets are nervous, insurance cost rises. You need to buy insurance before the event, not during or after it.

Buying long-duration govies is also a way to insure your portfolio. When equity markets crash and there is a flight to quality, investors may rush into the safety of govies. They should perform well, offsetting some of equities’ poor performance.

Active management is taking dynamic decisions to manage risks. It usually should precede the risky event. Otherwise, taking action after the fact might be too late.

For example, you have a 50% equity and 50% bond portfolio. Yields of 10-year gilts are at a 2% level. You think they might rise to above 3% since the UK economy accelerates. You can reduce your gilt exposure to 30% and increase your equity allocation or allocate some to cash to reduce risk.

If you did not take any action and yields have, indeed, risen to 3% then you need to decide whether to take action or if it is too late. You have already lost on your gilts. This is sunk cost. The question is whether you think yields are likely to move higher from here or fall back lower – look ahead, not backward.

If you still think they are likely to move higher, sell some gilts. If you think they are likely to fall back, keep holding your position or buy more gilts because their price is more attractive now.

Risk management is a continuous activity. Always think about what can go wrong.

Implementing a solution

We have almost reached the end of the investment management process. After formulating objectives, designing a plan and implementing it, it is now time to review. Are you on track to achieve your goals? Is the plan working? Do you need to change and adapt anything?

Answering such questions is the role of reviewing.

Summary

• Risk measurement is quantifying your portfolio’s risk.
• Volatility is the simplest way to measure risk. However, downside risk is the true risk of investing.
• Stress test your portfolio to understand how it would have performed during different situations.
• Risk management is actions and techniques to control portfolio risks. The four types of risk management techniques are: (1) diversification; (2) hedging; (3) insurance; and (4) active management.

Notes

¹ Monte Carlo simulation is often used for stress testing. The simulator generates random returns of assets, considering parameters such as their return distributions and correlations. Repeating the process many times produces a simulated distribution of the portfolio’s returns.