The downside of downside risk management.
Despite the postelection rally that delivered robust returns for U.S. equities, 2016 was a decidedly volatile year for markets. With heightened market volatility came increased discussions about risk management. This is a common response, and when volatility returns—which it always does—the popularity of risk-focused approaches and products will spike, too.
I take issue with most risk-management approaches and risk-based products (for example, controlled volatility or tail-risk hedging strategies) that stem from modern portfolio theory, or MPT, especially for long-term investors. My disagreement starts with the MPT definition of risk as short-term return variation, runs through the practice of portfolio diversification, and goes all the way to how risk-based strategies are managed and marketed.
A long-term investor can benefit from short-term volatility and can be harmed by overdiversification and costs from strategies that neither reduce the real risk of losing purchasing power nor improve the investor’s ability to achieve long-term financial goals. I’ll explore my thoughts on risk in greater detail below, but let’s start with a look at traditional risk management.
Risk Management, MPT-Style
Given investors’ rational desire to maximize the upside and minimize the downside, the definition and measurement of risk matter. If we’re going to manage risk, we first must know what it is and why it’s not always good for returns. And if we—or our clients—are long-term investors, the returns we should think about are long-term ones.
However, risk management in the MPT world (which most professional investors live in) is largely represented by the management of the movement and comovement of asset returns over short intervals using historical return data. Past relationships are extrapolated into the future, directly or indirectly. The cornerstone of MPT is measuring risk via the relative movement of market returns to produce metrics such as beta and alpha—terms related to the defunct capital asset pricing model, or CAPM. These frameworks rely on econometric analysis of monthly return data and use various forms of short-term return variation to measure and attribute risk.
In short, because of MPT’s focus on short-term variations, generating smooth returns has become the holy grail in our profession. For many investors, this is not only irrelevant but also can be expensive. The desire for smoothness reduces returns over time while not necessarily reducing the risks the investor should be worried about.
Early last century, a few investment theorists laid out those risks—namely, the risk of permanent loss of capital, the risk of being overly or needlessly diversified, and others. Somewhere along the way, the focus shifted from things that affect the long-term range of outcomes but are hard to measure to things that don’t matter as much to long-term investors but are easy to measure— that is, very short-term variations in asset returns.
Myopic loss aversion—or the combination of investors feeling more hurt by losses than helped by gains and constantly reviewing portfolio returns despite having a long-term focus—seems to have been codified into many investing frameworks and processes. This came not from inexperienced investors but from the professional investment management industry itself.