By Giralda Advisors

This is the capstone of our series on Risk-Managed Investing (RMI). In our initial piece, The Time Has Come for RMI, we described the RMI approach to equities as embedding volatility dampening and/or downside risk mitigation directly within the equity investment itself. In two other early installments, RMI and Investing in a Rising Rate Environment and RMI and the Liquid Alternatives Landscape, we outlined how RMI could be part of a solution to “the Portfolio Problem” caused by the disappointing prospects for non-equity asset classes.  With the background provided by all the subsequent articles (see archive here) — which spanned addressing such financial planning challenges as volatility drag and sequence risk; adding long-term alpha over complete market cycles; calibrating how low the cost of risk management needs to be in order to be worthwhile; exploring a range of RMI solutions in the marketplace; optimizing portfolios once RMI solutions are introduced into the picture; and examining the implications for portfolio performance measurement and benchmarking — we would like to return now to the Portfolio Problem and explore the profound impact that RMI can have in attempting to solve it.

The Portfolio Problem Revisited

We framed the Portfolio Problem as follows:  Equities are essential for most client portfolios but are subject to severe downside risk, and (this is the crux of the problem) what’s worked to buffer that risk over the last 30 years — diversifying into non-equity asset classes — is extremely unlikely to work well over the next decade or more.[1]  This is a phenomenon unique in the careers of most financial advisors.

A backdrop to this Portfolio Problem is another issue, and one of long standing.  Diversification itself is unreliable.  It always has been.  Diversification benefits are not guaranteed.  The low (or even negative) correlation among various “diversifying” asset classes is merely a tendency, not a law of nature.  And it’s a tendency that tends to disappear when the investor needs it most to prevail, i.e., when markets enter a period of extreme stress.  Now, diversification — in its most effective form, which includes scientific asset allocation and rigorous rebalancing — remains a prudent portfolio construction approach in our view, but it should be recognized that it was never designed to manage severe market risk and contagion.  In other words, simply assuming that asset classes that diversify each other in calm markets will continue to do so when you most need them to do so has never been a sound assumption, and is one made at the investor’s significant peril.

And now, against this backdrop, the asset classes that advisors have spent their careers relying upon appear to be poised for historic levels of disappointing performance.  The Portfolio Problem is a significant one indeed, and it should be clear that counting on solutions that may have worked in the past is an imprudent strategy for a professional financial advisor.

A Different Solution Is Needed

We need a new solution.  It should come as no surprise to followers of our series thus far that Risk-Managed Investing (RMI) — the attempt to embed downside risk management directly into the equity investment itself — is by far the most promising approach to the Portfolio Problem that we have examined. (Practical RMI solutions available in the marketplace are reviewed in RMI Applications: Sector Rotation Using ETFs, RMI Applications: Tail Risk Hedging, and Marketplace Review of Risk-Managed Investments.)

What makes RMI an elegant solution to the Portfolio Problem?

  • RMI satisfies the portfolio’s essential need for equities
  • RMI addresses portfolio risk directly at its source
  • RMI diminishes the reliance on “diversifying” asset classes to provide risk management
  • RMI does not disrupt the tenets of asset allocation; in fact, it explicitly addresses its weakest assumption, namely, that asset classes that diversify each other in normal markets will continue to do so during periods of market stress
  • RMI can raise the “efficient frontier” — as demonstrated in Risk-Managed Investing and Portfolio Optimization

As a result, RMI can allow “re-risking” of the portfolio, as we’ll now explain.

Re-Risking the Portfolio: 80/20 as the New 60/40

Let’s take another look at the efficient frontier graph we presented in Risk-Managed Investing and Portfolio Optimization.

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