Crisis In Investment Management. Never Allocate To Risk As A Single Factor.

July 8, 2022

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Bond market volatility and the Global Credit Impulse indicate a risk hurricane.

Best Investors always focus on minimizing risk.

[Ptolemy’s] Earth-centered universe held sway for 1,500 years, showing that intellectual brilliance is no guarantee against being dead wrong.”
Carl Sagan

“…at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.” 
Paul Tudor Jones

It has become an industry standard that asset management starts with a risk assessment of the investor. Once that is completed a portfolio is selected which in theory “matches” the investor’s risk profile. In most cases once the portfolio is allocated there is limited activity until the next review or interaction with the investor.

This process may have been sufficient for purpose for many investors in the relatively stable conditions and broadly benign investment environment of the last decade. However, in today’s markets it is likely to become clearer that risk based allocation and passive management is somewhere between suboptimal and simply dead wrong.

This does not mean that there aren’t times to take a higher level of risk. It does mean that even when the return opportunity justifies higher risk, the risk then needs attention and clear active management.

Did you really ever complete your own Investment Due Diligence?

Indications Of A Risk Hurricane

Record levels of volatility are now testing investors as never before. The chart below shows that not only are average equity volatility levels broadly higher, but more importantly, bond market volatility levels are back at the highs of March 2020.

It is increasingly the credit side of bonds that is in trouble. More specifically, the G5 global credit impulse has now collapsed below even the level of the GFC in 2008.

The credit impulse “…measures the pace of change of credit creation in the 5 largest economies worldwide and it serves as a very reliable leading indicator (6-15 months lead time) for economic growth and the performance of several asset classes.

This is not the time to be disengaged with your investments and passively invested.

Investment due diligence is not complete until:

1. A clear investment objective has been set, with appropriate metrics that measure your progress, so that you can adequately assess your results in both the near term, and more importantly in the long term.

2. The most successful investors of all time choose their objective as “Capital Preservation and Compounding returns for the long term.”

3. The investment priorities flow from this investment objective providing great clarity for full accountability and assessment in real time, once a few key metrics are provided.

4. The metrics to assess your progress should be availalble to investors to access in real time. This should be the minimum requirement for investors. The metrics are easy to calculate and provide. They are simply the standard deviation of daily returns, drawdown, return relative to risk (both in absolute terms, and relative to a range of benchmarks), and annually compounded return.

5. These metrics can all be combined into a simple table, which will reveal in a few seconds how well you stand up to Best Investor metrics, and what this means for your long term capital preservation and compounding.

Here is an example of what you could see. The data shows the performance of a range of benchmarks in the first half of 2022. The green dot represents your portfolio which you can then compare to the benchmarks on both risk and return. If you are above and to the left of your benchmark you are in great shape. If not you may have work to do.

The data on the portfolio is just for educational reasons and does not represent any form of performance declaration.

Allocation to risk as a single factor rests on a number of challenging assumptions:

1. Individuals clearly do not have a stable attitude to risk. This has been well documented through allocation data and sentiment indicators for decades. How do you allocate to a variable which is in addition hard to define?

2. The volatility of market volatilty is substantial. Even if future risk could be calculated, whatever portfolio is chosen will experience massive changes in volatility. The VIX measures the volatility of the S&P 500 and it varied between 11 and 88 just in one month in March 2020.

3. The real risk of a portfolio is what happens to it from the moment it has been allocated. What is crucial to the investor is how well the risk is managed. This can only be measured using the table above. This makes the investment manager accountable to what really matters. Investors need to see that their accounts are safe and compounding whenever they want to!

Big drawdowns of account value make compounding positive returns very difficult over any time horizon. All of the most successful investors realize this and mange their accounts accordingly. This is a core element of their long term success.

An investment manager who allocates to risk and invests passively can not be accountable to these risk metrics. Is that acceptable to you?

The stardard deviation of returns and drawdown can be calculated and this clearly shows what is in store in terms of capital preservation and compounding. If you do not monitor this you are failing your own due diligence.

The regulators seem to recognize this. FINRA states:

The bottom line is all investments carry some degree of risk. By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals.”

If your investment manager says they can’t time the market, believe them, they probably can’t. Unfortunately, risk mangement does require active management. You need another investment manager with a track record.

Make sure you understand the difference between Best Investors and everyone else, and the significant difference it makes.

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