Changing The Way You Invest- Managing Risk, Not Predicting Return

By: Dominick Paoloni, CIMA®

 

With the market dropping over 400 points on Friday, June 6th on the back of increasing unemployment numbers and an increasing possibility of recession, the average investor is looking for answers about what to do.

All the financial pundits on television and the print media are giving opinions from selling one asset class, like financials and manufacturing, to buying another asset class, like technology and health care. The problem is that one expert is telling you to buy an asset class while the next analyst is telling you to sell.

Everybody is making bets one way or the other.  To compound the problem, if history is any guide most analysts are right about half the time.  A coin toss or a monkey throwing a dart is just as accurate.  I always like to quote from a Barrons article I read back in 2003 which quoted an oil expert saying that oil can’t go any higher than $35 a barrel.

If the average investor is struggling with what to do, and the evidence suggests that the experts don’t know what to do, than maybe it’s time to alter the way you invest. Instead of changing what you invest in, change how you invest. It’s time to stop trying to find the next hot stock or mutual fund and start investing your life savings in a way that is more controllable and more predictable.

Every stock, bond or mutual fund has three observable traits: The historical return, the historical volatility (a measure of risk denoted by standard deviation), and the historical correlation (the relationship of movement with other assets within the portfolio). Of the three traits the one that is most often used is return, yet it is the least dependable. How many times have you read that “past performance is no guarantee of future performance”? Buying investments that did well last year and selling investments that did poorly is the quickest way to go broke.

Eric Sorenson, who was the head of quantitative research at Salomon Bros., concluded that “Forecasts of the correlation of volatility can be modeled more easily than forecasts of the rate of return.”[1] Past correlation volatility, being a good indicator of future correlation volatility, gives us something we can put our teeth into.  Past correlation is by no means guarantees of future volatility and correlation, but by any measure it is far more dependable than return.

If an investor knew the volatility and correlation of the investments within the portfolio and made no assumptions about return, then the paradigm would shift from trying to predict returns to managing overall volatility or risk. For example, if an investor had an overall portfolio standard deviation (the quantifiable measurement of risk) of 10 and by remixing his asset allocation model could drop his volatility to 5, he just statistically dropped his downside risk by half

How You Make Your Money is More Important than How Much You Make

By controlling overall risk, you may limit your gain potential but more importantly you limit your downside. Think of it this way— if you lose half of your money you would have to make 100% return to get back to break even. Investors that got clobbered in the bear market of 2000-2002 are just breaking even today, 7 years later, which negates Einstein’s axiom that “consistent compounding of money grows wealth”. An inconsistent, high volatility portfolio produces poverty. This can be illustrated in the following chart (see fig1)

$100,000 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Annualized Return Total $ Standard Deviation
Portfolio A +80 -10 +40 -20 +20 -50 10% 108,864 46.4
Portfolio B +20 -5 +20 -5 +10 -5 5.8% 135,808 12.4

In the chart above, Portfolio A returned far better than Portfolio B in the first three years; however, portfolio B has far less volatility. This means that both your gains and losses are more contained. After the first year, an investor in Portfolio A should have realized his portfolio had too much volatility based on his huge gain. The question that he should have asked is, “I made a lot of money but how did I make it?” If the portfolio volatility was checked after year one, he would have realized that the overall portfolio had too much risk.  The volatility could have been controlled through correlation management and diversification, which would have reduced volatility. Even though Portfolio A has almost twice the annualized return of Portfolio B, at the end of the day portfolio B is worth more. As Mark Yusko, former Chief Investment Officer of UNC Chapel Hill, once said, “By not losing we’ll always win in the end, even if we underperform.”[2]

The Proof is in the Pudding

The question you need to ask your financial advisor is “How much overall portfolio risk, as denoted by standard deviation, do I own in my account?”  A referral recently walked in my office and asked me to evaluate his portfolio. After analyzing his portfolio I found he had an overall risk over 9.5, twice what it should be given his risk tolerance. Simply put, his variation of return was far too great for his investment goals. He asked if he should buy more bonds to reduce his risk, and I explained that the answer is not risk avoidance, but risk management. It’s not about buying more bonds, it’s about shifting assets that have non-similar movement (low correlation) in the portfolio to reduce risk but not necessarily return.

On a risk adjusted basis the IPS custom-built portfolios are ranked in the top quartile of Separate Accounts in Morningstar Database, showing historically low volatility with strong consistent return[3]. The lower you keep your portfolio volatility (standard deviation), the greater the chance of hitting your target returns on a yearly basis. If consistency builds wealth (as Einstein said), and money doubles every seven years at 10% compounded interest (according to the rule of 72), then you should monitor your volatility and stop chasing return.

 

[1] J.C. Louis, “Worrying about Correlation,” Derivatives Strategy 2 (1997).

[2] Yusko, Mark. “Living in a Flat World: The Global Search for Alternative Investment Opportunities.” Charles Schwab. Impact 2007, Las Vegas. 29 Oct 2007.

[3] Based on a risk-adjusted return Morningstar search within the 6,083 Separate Accounts listed in their database conducted June 10, 2008.

Disclaimer:
This article should not be misconstrued as a recommendation/offer to buy or sell, or a solicitation to buy or sell securities and should not be considered investment advice. The past performance of any investment(s) does not necessarily indicate the future performance of any investment(s). All investments have the potential for profit and the potential risk of loss. One should always consult an investment advisor before making any investment decisions.