This article is scheduled to appear as an invited editorial in the Winter 2013 issue of The Journal of Portfolio Management.
Risk management of investment portfolios can be visualized as a continuum of four distinct regimes. These regimes correspond to the potential size of losses; since larger losses naturally happen with lower probability, a natural and practical approach to loss mitigation seamlessly transitions among them.
For the smallest market fluctuations (e.g., 0% to -5%), perhaps the best way to manage risk is by dynamic rebalancing. In this method, investors use algorithms that target volatility and allocate with relatively high frequency between stock-like or bond-like instruments and cash.
To help protect against losses, say, from 5% to 15%, a realignment of the underlying betas, or key exposures, may be more useful. Predominant among these are alternative, diversifying betas such as momentum. The expanded palette of diversifying betas makes this exercise increasingly powerful and potent.
For even deeper losses (e.g., -15% to -35%), explicit tail risk hedging via option-like strategies may be more effective. Options may be the best way to outsource the jump-risk component of dynamic risk balancing, and for highly improbable events, this method of portfolio risk management is indispensable.
Finally, cash is indeed the ultimate king. For catastrophic loss events, there is no substitute for having a pristine source of liquidity.
Since losses can follow a continuum breaching these ad hoc boundaries, the mixture of risk management strategies one ought to use depends on one’s perception of the probability of losses of a particular magnitude and the market’s pricing of those same expected losses. However, it might be too narrow-minded to focus on only one regime and eliminate the benefits to be had from adding elements from the others.
The unifying framework that ties all four together is the application of an option theoretic approach to the relative pricing of each mode. Diversification has an option cost, since it requires one to give up yield in order to obtain correlation benefits. Investing in macro or commodity-trading-advisor strategies has an implicit cost from reading trends incorrectly (the “whipsaw”). Explicit options purchases have explicit costs. Finally, cash has a real option cost as well as an option benefit. It provides the investor with the choice to deploy capital later, but in the meantime loses nominal opportunity and real purchasing power.
Putting the four regimes in a common framework allows investors to consider the proper balance of risk vs. cost. It also allows us to think of what we can and should do to mitigate the short-term costs of prudence and risk management with long-term gains from more favorable (and, yes, sometimes aggressive) portfolio repositioning. In a world where policy risk is one of the predominant drivers of asset returns, having an open-minded and dynamic approach to managing portfolio risk for all magnitudes of positive and negative surprises is no longer a luxury, but a necessity.