Are There Blindspots in Your Clients’ Portfolios?

By Karan Sood via

Retail investors want three things: asset growth, liquidity at specific points of time in the investment lifecycle, and protection against losses when they capitalize on that liquidity. It doesn’t sound unreasonable, does it? Yet the way that most retail investor portfolios are constructed leaves the investor with serious blind spots.

The traditional approach advocates building a diversified portfolio of asset classes, based on the investor’s risk tolerance. Sounds great, on paper.

However, when analysts evaluate investments for inclusion in portfolios, they use conventional metrics such as annualized return, volatility (e.g., standard deviation), and correlation of returns, none of which account for liquidity timelines and protection against losses that match those timelines. Take volatility as an example. It is used as a key theoretical measure of risk. However, it disregards that the possibility of losing money—or having less of it when needed—is the real and absolute measure of risk. While the two measures are related, the traditional approach assumes them to be the same thing.

It is not surprising then that techniques devised to reduce volatility may fail to reduce risk. The volatility-reducing power of diversification, once hailed as the Holy Grail, failed spectacularly twice in the last decade—in 2001 and 2008. At both those times, numerous asset classes collapsed all at once. That’s because the extent to which asset classes move together is both dynamic and unpredictable.

The sudden high correlation among many of the world’s major asset classes in those times was likely not a rare event, but rather the inherent reaction of ever-more-connected dynamics across multiple markets. Even investors with diversified, supposedly non-correlated investments can experience short-term negative returns more often than expected. And if negative returns occur when liquidity is needed (e.g., for retirement, for children’s college tuition, or for a down payment on a home), the results can be disastrous.

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