Tag Archives: risk

How To Best Gauge Your Risk Tolerance

By Larry Cao, CFA Understanding an investor’s risk tolerance is arguably the single most important issue for an investor and their financial adviser to consider. And yet it never seems to get the attention it deserves. The Definition Risk tolerance refers to your ability and willingness to take on investment risk. Specifically, it indicates how big of a loss you can take in the market without changing course. We are all human and abandon ship when things go wrong. (And that’s why we are not fully invested in equities even when it comes to our long-term investments.) Risk tolerance is the threshold at which you’ll head for the exits. It’s important to measure your risk tolerance accurately. Otherwise all your financial plans are just sand castles and won’t withstand the test of time and market volatility. “I did not really understand my true risk tolerance.” This is one of the painful facts many investors came to appreciate following the global financial crisis. Financial institutions often offer their wealth management clients a risk tolerance questionnaire as a way to gauge their risk appetite and capacity to withstand loss. Investors are typically asked anywhere from a few to multiple sets of questions on their investment horizon, their reaction to different levels of market volatility, and sometimes other factors, such as their education, that regulators or financial institutions may deem relevant. The Issue There are two problems with the current risk tolerance questionnaires and how they are administered. First, is the question of what motivates a financial institution to administer such a questionnaire. Far too often, the questionnaire is the product of internal (compliance) and regulatory considerations. Therefore, the questions may not have been designed to accurately measure your risk tolerance. Second, financial advisers, whether fee- or non-fee-based, are directly rewarded for persuading clients to trade or invest with them. Risk tolerance questionnaires are often treated as a hindrance to profit rather than a tool to gain a client’s trust. I think it’s for these reasons that the single most important question for accurately gauging investor’s risk tolerance often does not get asked. That question is: How often do you check your investment performance? The Solution How frequently you look at a Bloomberg Terminal, check your stock performance on a smartphone, or, in a more old fashioned way, call your broker actually matters quite a bit in understanding your risk tolerance. Run-of-the-mill questionnaires generally give ranges of upside and downside related to investment strategies, in dollar amounts or percentages, and ask which one you’d invest in. The horizon is generally assumed to be a year – that’s how often financial advisers typically meet with clients to discuss financial plans. And yet, what these ranges mean to an investor very much depends on how frequently they check the market. As a service to readers of CFA Institute Financial NewsBrief , we asked them that question. (To avoid ambiguity and guesswork, the question was phrased differently in the poll.) And below are their responses. When did you last check your investment performance? Click to enlarge About 41% of the 558 respondents actually checked their performance within 24 hours (including 7% who checked within the hour?!). Imagine the constant pounding they’ll get in a bear market. In fact, if you are part of this group, just think back to how you felt this January. Experience shows that this group is more likely to overstate their risk tolerance on questionnaires and, hence, are most vulnerable to market volatility when it actually hits. When I was a professional money manager, I belonged to this group. It’s kind of a responsibility that comes with the job. But it is just as hard for professional investors to stomach market turmoil as anyone else. As I recall, in the midst of the financial crisis in 2008, when I asked a portfolio manager from a different firm how morale was in the office, he said, “It is really quiet.” By the way, I am not saying all portfolio managers have to monitor their performance this closely. It depends on how your investment strategy works. For example, value strategies tend to require longer investment horizons, so it’s generally okay if a manager does not check portfolio performance every day. The largest group of our survey respondents (40%) check on their portfolios every month. For most investment strategies and most investors, I think that’s probably the optimum. Still, in terms of gauging one’s risk tolerance, that’s a frequency higher than implied in the risk tolerance questionnaire. So this group suffers from the same problem as those noted above. That adds up to about 80% of investors who are probably overestimating their risk tolerance. How frequently you make your investment decisions has direct impact on your risk tolerance. If you invest you own money, make sure you ask yourself that question. If you are a financial adviser, consider asking your clients that question today. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Risk Rotation Portfolio: A Strategy For Retirement Accounts

Summary What is the Risk Rotation portfolio? How to construct and manage a Risk Rotation portfolio inside a 401K type of account. How does a Risk Rotation portfolio perform compared to the broad market? What is the Risk Rotation Portfolio? The Risk Rotation (or Asset Rotation) portfolio is not something new. One can find many variations for such a portfolio on the Internet. In the SA community, you can find several articles and contributions on similar and other Asset Allocation strategies by Frank Grossmann , Varan , Joseph Porter and others. In brief, the core principle in a Risk (or Asset) Rotation portfolio is to periodically move (or rotate) assets out of an asset with a higher downside risk to an asset that has lower downside risk and higher upward momentum. Such a portfolio aims to provide much lower volatility and drawdowns while capturing similar (or better) returns as the broader market. Though such a portfolio can be constructed inside any brokerage account, I personally find them more appropriate for retirement accounts. Risk Rotation portfolio for retirement accounts Investing successfully has never been easy. Even for the most disciplined investors, the market’s volatility sometimes takes its toll. The past few months have been an emotional rollercoaster for many folks, especially for those closer to retirement. If your horizon is very long term, this is simply market noise and best be ignored. However, for anyone who is already retired or close to retirement, any sharp correction has the potential to derail their near and medium-term planning. The big question is how do you protect yourself from a market downturn or an outright crisis like the one we had in 2008? Furthermore, most retirement accounts like 401K accounts do not provide the flexibility to buy individual stocks or even ETFs (Exchange Traded Funds). A vast majority of them provide just a handful of funds to invest. So, you cannot select your own dividend paying stocks and follow a DGI strategy. In my opinion, one good option is to construct a Risk Rotation portfolio. In my own experience, and also based on back testing, such a portfolio will provide market-beating returns in most situations while providing a high degree of risk protection. A disclaimer: I am also a believer in DGI strategy, and personally invest the majority of my investible funds in individual stocks that pay and grow their dividends. However, for accounts where I cannot invest in individual stocks, I follow the Risk Rotation strategy for about 50% of such assets. If you are interested in my other portfolio strategies, I publish a ” Passive DGI Portfolio ” and another portfolio that is Income-centric named ” The 8% Income Portfolio ” on SA. How to construct a Risk Rotation portfolio: I believe in keeping things simple so they can be easily followed long term. As an example in this article, I will use two securities (a pair of two securities). This pair can be easily implemented inside a 401k type account with moderate risk. There can be more aggressive pairs or strategies that promise higher returns (with higher risk obviously), but they cannot be easily implemented inside a retirement account. Moderate Risk strategy: SPY and TLT pair SPDR S&P 500 ETF (NYSEARCA: SPY ) is an ETF that corresponds to the price and yield performance of the S&P 500 Index. Almost all of the 401K or retirement accounts would offer something that is equivalent of S&P500 index. SPY is taken as an example to illustrate, but any similar fund or ETF can be used in place of SPY. iShares 20+ Year Treasury Bond (NYSEARCA: TLT ) is a 20+ year Treasury fund and oftentimes provides the inverse co-relation with stocks. One can find something similar to TLT inside a retirement account. If nothing similar is available, it could be replaced by cash or cash-like money-market funds. However, the back-testing results by using cash are not as impressive as with TLT. One reason is that TLT provides some yield and at times meaningful appreciation, but cash provides neither (though money market funds do provide some minimal yield). On the first of every month, compare the performance of each of the two funds with a 3-month (or 65 trading days) look-back period. – Invest 70% of the allocated amount in the fund that has better performance over the last 3 months – Invest 30% of the allocated amount in the fund that has worse performance over the last 3 months – If the look-back period performance has been the same or nearly same, invest 50% in each of the two securities. – Repeat every month, on a fixed date of the month. It can be 1st of the month or any other date. Low Risk strategy: SPY, TLT and Cash For more conservative investors, a strategy that involves adding cash to the basket (SPY and TLT) will work a little better. This will also work better during times when both stocks and Treasuries are headed down. This strategy will provide much lower drawdowns, however, at the cost of some performance or overall returns. – On the first of every month, compare the performance returns of each of the three funds with a 3-month (or 65 trading days) look-back period. Performance of cash being taken as 0%. – Invest 60% of the allocated amount in the fund that has better performance over the last 3 months – Invest 30% of the allocated amount in the fund that has second worse performance over the last 3 months – Invest 10% of the allocated amount in the fund that has worst performance of three funds over the last 3 months – Repeat every month, on a fixed date of the month. It can be 1st of the month or any other date. Performance comparison: RRP Strategies vs. S&P 500: (click to enlarge) Image1: Performance/Returns – RRP Strategies vs. S&P 500 The table above shows the performance/returns of the Risk Rotation portfolio (RRP) starting with the year 2006. Row 12: Shows how the portfolio would have performed versus S&P 500 if we had invested $100,000 on January 1, 2006 and remained invested until 10/30/2015. Row 11: Shows how the portfolio would have performed versus S&P 500 if we had invested $100,000 as of January 1, 2007 and remained invested until 10/30/2015. And so on… Notice, except for two starting years (2012 and 2013), the RRP either matches or handily beats S&P 500 with much lower drawdown. The main benefit that stands out is that it moves the portfolio away from the risk in a crisis situation that we witnessed in 2008. I did not go back to the year 2001-2002, but I expect similar behavior. (click to enlarge) Image2: Growth of $100,000 starting on 1/1/2006 – RRP strategy vs. S&P 500. (click to enlarge) Image3: Monthly drawdowns since year 2006 – RRP strategy vs. S&P 500. (click to enlarge) Image4: Maximum drawdown since year 2006 – RRP strategy vs. S&P 500. Risks from this strategy: Let’s consider some potential risks: The first risk comes from the fact that we are seeing the performance comparison based on back-testing results. As the adage goes, past performance is no guarantee of future results. TLT or any other equivalent fund would invest in a treasury based bond fund. In a rising interest rate environment, TLT may have inferior performance compared to past. However, this risk should be mitigated by the fact that we are checking the performance of the two securities every month and switching if necessary. Lack of Diversification: For the stocks component, we are investing in SPY (equivalent of S&P 500), so there is not much exposure to any of the international markets or other asset types like gold or commodities. However, this is partially mitigated by the fact that the companies inside S&P 500 earn a lot of their revenue from outside of the US. Another risk comes from the fact that oftentimes, the performance of this portfolio will be different than the broader market. If it happens to be negative compared to the broader market for a couple of years, the investor may lose conviction and the discipline and may abandon the plan mid-course. This probably is the biggest risk. Concluding Remarks: As they say, hindsight is 20:20. It is hard to predict with any certainty that such a strategy will work as well as it has worked in the past. That’s why it is important to not keep all of your eggs in one basket and depend too much on any one strategy. In my opinion, for the long haul, this strategy should at least match S&P 500 performance with much lower drawdowns, and hence should allow much better sleep at night. I am starting out a sample portfolio with $100,000 initial capital allocated as of November 3, 2015 and will provide regular updates. I plan to publish the performance comparison of the two securities (SPY and TLT) with the previous 3 months’ look-back period on or after the first trading day of every month. This will indicate if a switch of assets is required for the strategy. Here is the relative performance of SPY and TLT as of November 2nd with 3-month look-back period: Price (adj. close) on 11/02/2015 Price (adj. close) on 7/31/2015 Performance/Return Over last 3 months TLT 121.95 121.75 0.16% SPY 210.33 209.36 0.46% Source: Yahoo Finance Since the performance is nearly the same for both, the strategy will invest 50% of $100,000 in each of the two securities. Full Disclaimer: The information presented in this article is for information purpose only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Every effort has been made to present the data/information accurately; however, the author does not claim for 100% accuracy. The portfolio or other investments presented here are for illustration purpose only. The author is not a financial advisor, please do your own due diligence.

Was Dalio Risk Parity Strategy Responsible For Recent Turmoil?

Within minutes after the opening bell on Black Monday, August 24, the Dow plummeted 1,089 points, surpassing even the flash crash of 2010. Dramatic declines caused stocks and exchange-traded funds to be automatically halted by stock exchanges more than 1,200 times. The market remained volatile in next weeks also, pulling down both the Dow and the S&P 500 indices down by more than 6 percent in August. The risk parity strategy, pioneered by Ray Dalio, the founder of world’s largest hedge fund, came under fire for this market volatility. The risk parity investment strategy was developed and first adopted as All Weather Fund in Bridgewater Associates in 1996 and has become increasingly popular in the industry. This has been one of most successful investment strategies since last two decades. But its recent performance has been poor. Of late some analysts and fund managers such as Lee Cooperman of Omega Advisors have started blaming the risk parity strategy for the market turmoil seen in recent weeks. This pushed Dalio to a defensive position, prompting his firm to come out with a report for its clients defending his risk parity approach. The Bridgewater report tries to dispel many of the concerns surrounding risk parity and the All Weather fund. Let us see what this risk parity strategy is, how it works, what blames are and what Dalio wants to say. What is All Weather risk-parity strategy and how does it work? The risk- parity strategy is Bridgewater’s flagship strategy, known as All Weather strategy. It is one of the two investing strategies consistently followed since last two decades by Bridgewater Associates, the world’s largest hedge fund with $170bn in assets under management. While the Bridgewater’s other strategy, known as Pure Alpha, is a traditional hedge fund strategy, All Weather is a risk-parity and leveraged beta strategy. It is based on the philosophy that there are four basic economic scenarios: rising or falling growth, rising or falling inflation. And different class of assets behave differently in each of these economic scenarios. The risk-parity’s objective is to reduce the volatility of investing in assets that normally move in the opposite direction in different economic environment. The All Weather strategy allocates 25% of a portfolio’s risk to each of these scenarios. It is allocation of risk and is different from allocation of assets. The portfolio makes money in any economic environment and is considered as a solid strategy in both good and bad markets. All Weather has given 8.95 percent average annual return since its inception in 1996. Its long-term success has helped the industry expand. But this August, $80bn “All-Weather” risk parity fund lost 4.2 per cent and is down nearly 5% YTD. The famous all weather strategy is facing rough weather from critics. What are blames on the risk parity strategy? First, the risk parity strategy allocates assets based on volatility. The ‘smart beta’ passive equity strategies adjust their exposures according to algorithms in response to market moves. The risk parity funds and momentum investors known as CTAs are typically computer driven. Any in volatility can trigger a rash of automated selling. Second, the risk parity strategy involves use of leverage, derivatives and borrowed money, to amplify their bets tied to the performance of bonds, stocks and commodities. Fund Managers often shift their allocations of assets to maintain an equal distribution of risk. They invest passively in a range of financial assets according to their mathematical volatility. In August as volatility increased, these funds are accused to have begun selling with increased intensity. The selling created more selling. This effect then cascaded through markets, and asset correlations increased. As a result assets like stocks and bonds, which often trade in opposite directions, began to fall at the same time. Market collapsed. The risk parity strategy too underperformed. What does Ray Dalio say in defense of risk parity strategy? The inventor of risk parity strategy, Ray Dalio, strongly defends his strategy and Bridgewater’s approach amid criticism. While the strategy might occasionally underperform other investment techniques, but it was still the best long-term strategy. Unlike other funds, Bridgewater does not tend to sell assets when prices fall and buy them when prices rise. It does the opposite to rebalance to achieve a constant strategic asset allocation mix. All Weather portfolio is well diversified so as not to be exposed to any particular economic environment. It has no such systematic bias to do better when interest rates are falling compared to that when they are rising. So it is not vulnerable to a bond sell-off. Dalio says Bridgewater is not responsible for the stock market increased volatility seen last month. Relative to the size of global asset markets, the risk parity strategy funds is too small to move market. It is like a drop in the bucket. Allocations are not adjusted due to swings in volatility, and therefore could not have created the market impact. “All Weather is a strategic asset allocation mix, not an active strategy. As such, All Weather tends to rebalance that mix which leads us to tend to buy those assets that go down in relation to those that went up so that we keep the allocations to them constant. This behavior would tend to smooth market movements rather than to exacerbate them,” fires back Dalio in the Bridgewater Report .