Current market environment performance of dynamic, risk-managed investment solutions.
By Jerry Wagner
“Nothing is certain except death and taxes,” Benjamin Franklin famously observed. I would add one more certainty to that list: risk.
The specific risks we face change over time and vary by circumstance. In today’s world, which seems to be growing ever smaller, the risks faced in one corner can be very different from those encountered in another.
What is constant is that, regardless of circumstance, location, or century, risk remains an integral part of our lives. It is an everyday element. It is always with us.
We are very aware of some risks and probably overemphasize their influence. News programming often seems designed to keep us in a constant state of distress, described by some as “a horror movie from which we don’t get to go home.” But I do not think we should let this induced “culture of fear” overcome us—especially when it comes to how we think about risk in our financial lives.
On the contrary, as an entrepreneur, I believe that opportunities arise from taking risk. Fear of risk, by contrast, can overwhelm and paralyze.
If risk is always with us, yet an overfixation on it can be detrimental to how we live our lives, how should we think about it? As with most fears, the best response is often to learn more about it and understand how it affects us, helping us achieve a better sense of balance.
There are many types of risk. Investors face at least three main types, and each must be approached differently.
Unavoidable risk
The first type is probably the least likely, but it often seems to be the most feared. This is unavoidable risk—the risk that something bad will happen no matter what you do. Some people, including some investors, behave as though this kind of risk is far more common than it actually is.
In investing, whether in bonds or stocks, we know that volatility and bear markets are inevitable. Even so, we can take steps to help mitigate the effects of these declines. Asset and strategy diversification, combined with dynamic risk management, can help diminish losses, even if such measures cannot always avoid them entirely.
Improbable risk
The second class of risk involves those that are improbable—risks that occur only a small percentage of the time. These tend to push us toward one of two responses: ignoring them because they are unlikely to happen or slipping into the paralysis of a broader culture of fear.
We see this pattern often in how people react to alarming headlines or isolated events. In investing, everyone has heard stories of someone who lost everything during the Great Depression or a major financial crisis. These market collapses are extremely rare, yet they do occur. However, focusing on them can distort perspective and lead to inaction.
Some investors experienced significant losses during the brief but sharp bear market in early 2020. Many were then punished again when they remained on the sidelines during the recovery that followed, having overemphasized the risk of another crash.
There is a solution to this type of risk: working with a financial adviser to build a portfolio of investment strategies that includes both a defensive plan to exit the market when conditions deteriorate and an offensive plan to reengage when conditions improve.
Probable risk
The final type of risk is probable, or realistic, risk—the kind we can reasonably anticipate. We’re told that if you smoke, lung and breathing difficulties are likely. If you drive a car, some type of accident over your driving lifetime is probable.
Probable risks are everywhere around us. They permeate our lives. Yet despite their prevalence, our minds are wired to assess them quickly and take prompt action.
The human brain evolved to deal with probable risks in this basic way, and it served our early ancestors well. Faced with immediate danger, they had to decide instantly whether to fight or flee, and that instinct helped them survive a hostile environment.
Modern life, however, presents far more complex decisions. Studies show that humans are not very good at weighing probabilities, and even trained statisticians can be misled by the brain’s tendency to reject the more probable of two outcomes.
This often stems from an overreliance on recent experience. For example, a down day, week, or quarter in an investment can easily be extrapolated into the future, leading to fear. Loss aversion compounds the problem. Research shows that the fear of losing a dollar has a greater influence on decision-making than the prospect of gaining more than two dollars.
As a result, some investors allow recent market activity to derail a well-constructed investment plan or strategy. Fear of loss can overshadow the satisfaction of future market highs and prompt an investor to abandon a stock, bond, or strategy after a single disappointing quarter.
Yet it is unlikely that the original investment decision was based on one quarter’s return. More often, it reflected confidence built on years of performance, not a short-term setback.
While misjudging probable risk can lead us astray, there is also a positive side to this category of risk. Probable risks are anticipatable and, to some extent, controllable. You can stop or limit smoking. You can insure against a car accident. And in investing, you can adjust or reformulate your portfolio.
A solution to all three types of risk
Dynamic risk management can help address all three types of risk within an investment portfolio.
Bear markets tend to fall into two broad categories:
To cope with the baby bears, a simple passive allocation can be an effective tool. Even better, in my opinion, is a multi-strategy core portfolio.
Multi-strategy core portfolios are suitability-based and use multiple strategies that include asset-class diversification, strategy diversification, and dynamic risk-management measures—rather than the asset-class diversification alone used in traditional passive asset allocation. These portfolios can help keep investors engaged in the market most of the time while seeking to avoid whipsaws and sharp, shallow corrections.
In contrast, tactical strategies (such as our Classic, QFC Self-adjusting Trend Following, and Volatility Adjusted NASDAQ strategies) and dynamic rotation strategies (such as our Evolution and Market Leaders strategies) are often better suited for the “explore” portion of a portfolio, designed with super bear markets in mind.
Tactical strategies can move entirely out of stocks when necessary to help mitigate the steep losses associated with super bears. Dynamic rotation strategies can become increasingly defensive as market conditions deteriorate, eventually shifting to cash or bonds to sidestep the severe part of a decline. Both approaches rely on tested methodologies to reenter the market when conditions improve.
By combining multi-strategy core portfolios designed to manage baby bears and tactical and rotational explore strategies aimed at super bears, investors can build portfolios that address all three types of risk. Dynamic risk management makes this possible.
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Each of us must remember that risk is real and that, like death and taxes, it is always with us. The goal is not to be paralyzed by risk, but to anticipate it, understand it, and seek to manage it thoughtfully.