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Managing Your Portfolio: Managing risk

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One of the most widely accepted portfolio management theories resulted from a study in 1986 by Brinson, Hood, and Beebower. The study concluded that 93.6% of portfolio variation could be explained by asset allocation. Although this study has its merits, one might argue that portfolio variation can be explained by market movements. Before placing your portfolio into a long term buy-and-hold allocation there are some things you may want to consider.

Unlike today, this study was conducted at a time when the world markets had lower correlation with each other. Over the last 25 years, world economies have become more interdependent and thus much more correlated. What this means is that when European and Asian markets are facing challenges, domestic markets are also being challenged. Furthermore, this theory became available at the beginning of one of the largest secular bull markets in history. Buy-and-hold investment strategies tend to work well in long term secular bull markets but as you may have experienced more recently, they do not hold up as well in secular bear markets. Let's take a look at some different and very basic strategies.

Some investors seek out value opportunities within an under-performing sector or even a security that may have pulled back due to any number of exogenous events. Other investors are willing to pay up for companies with high growth rates with the expectation that the company will continue to grow faster than its peers. Both of these strategies have their benefits but when applied to portfolio management, they usually fall into a long term buy-and-hold strategy.

More recently, we've seen a greater number of alternative investments such as managed futures and hedge funds that, due to their low correlations to the market, can often compliment a portfolio by lowering the risk compared to the market. Despite these more widely accepted investment strategies, many investors have come to expect that if the market is up their portfolio will be up and conversely, if the market is down their portfolio will be down. Investors may want to consider broadening their traditional asset allocation strategies by adding risk management strategies.

The process of risk management builds upon existing asset allocation methodologies by attempting to minimize downside market capture and maximize upside capture. The goal of this process is to lower exposure and become defensive to the markets when risk is high and identify lower risk entry points and increase exposure when market risk is low. In other words, it's a disciplined process of attempting to buy low and sell high and it goes against our nature to sell when markets are down and buy when markets are doing well.

Most measures of volatility, which are often used synonymously with risk, fail to register until well after a market correction is underway. Consequently, many portfolio managers that attempt to manage risk continue to raise more and more cash as the portfolio or the market continue to decline. Essentially what they are doing is selling at low prices and waiting for better markets to present themselves before buying again. The problem is they are systematically selling more at lower prices and buying more at higher prices as part of their discipline. There are a few methods for combating market volatility

Two methods that can offer some relief are Risk Managed Tactical Asset Allocation (RMTAA) and Risk Managed Absolute Return (RMAR) portfolios. RMTAA is an active management portfolio strategy that re-balances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors with a focus on managing risk in the portfolio. Rather than allocate evenly across different sectors and assets classes, RMTAA focuses on the selection of favored sectors or even securities that are in favor and holding those securities until they fall out of favor.

Similarly A Risk Managed Absolute Return portfolio (RMAR) seeks to make positive returns by employing investment management techniques that differ from traditionally managed portfolios. Rather than pursue market returns a RMAR portfolio pursues a specified growth objective such as inflation plus a fixed rate of return. Other RMAR portfolios may choose to achieve a purely fixed rate of return regardless of how markets perform. If a portfolio manager can set a reasonable percentage goal, instead of attempting to outperform the market, the manager can focus more on risk and potentially create more predictable results for your portfolio. This also allows the portfolio manager to sit on the sidelines and wait for lower risk entry points into the market and furthermore, to raise high levels of cash when the objectives have been met or when market risk increases.

The process of risk management will be explained in greater depth as we explore the following questions over the next series of commentaries:

  • What to buy?

  • When to buy?

  • How much to buy?

  • When to sell a winner?

  • When to sell a loser?

  • When to sell a laggard?

If you like this article and would like to be notified of future Knoxville Investing Examiner articles, please click the confidential Subscribe” button above this article. Enter your email address and upcoming article links will be sent to you at no cost. Christopher DeMaria also serves the Knoxville area through DeMaria Financial Services. Call today (865-332-5952) to schedule an appointment. or to reserve a seat at our next complimentary educational seminar.

Source of Study: Determinants of Portfolio Performance Financial Analysts Journal Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower July/August 1986, Vol. 42, No. 4: 39-44

Other Sources: American Independence, Post – Modern Asset Allocation article.

The information contained in this report or information provided does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation of an offer to buy or sell any security referred herein. Past performance may not be indicative of future results. Christopher G. DeMaria is registered with and securities are offered through Kovack Securities, Inc. Member FINRA/SIPC. 6451 N. Federal Highway, Suite 1201, Ft. Lauderdale, FL 33308 (954) 782-4771. Advisory services offered through Kovack Advisors, Inc. DeMaria Financial Services is not affiliated with Kovack Securities, Inc./Kovack Advisors, Inc.

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