Home > Articles > Business & Management > Finance & Investing

This chapter is from the book

Moving Forward

It would seem that knowledge of the limitations and the empirical facts of the last decade would have forced change by now. But it hasn’t. An industry survey published in 2011 says that despite the renewed focus on risk management, a wide gap still exists between mean-variance and quantitative strategies.

  • Investment managers at financial institutions know, in principle, that basic mean-variance portfolio theory has it limits, but our findings clearly show that, in practice, mean-variance analysis is still the industry workhorse. Possibly to blame for this state of affairs is an absence of consensus on the most appropriate model.9

If we cannot rely on current practice and there is no consensus on how to move forward, what is the next step? How do you frame the possibilities? In the end, maybe it is a matter of taking a step back and asking the fundamental questions. The most basic question is: as investors what do we want and what tradeoffs are we willing to make? One of the answers that I think frames the issue as well as any I have seen is from the Ennis article mentioned above.

  • Investors want three things. They want some downside protection. They want to capture the equity risk premium to the maximum extent consistent with their preference for downside protection. And most would also like to garner excess return (alpha), although we know that, by definition, only about half do so over any particular span of time.10

I think he is exactly right. Downside protection will always be in demand. Equity risk premiums have historically been 2% to 3% over bond returns. Over long periods of time, this risk premium has been responsible for incredible wealth creation. And with research and other techniques, investors will always look for investments that will outperform market averages. Of course, different investors will put more or less weight on each objective. For example, institutional strategists may play more heavily in risk premiums. Aggressive traders will emphasize alpha and quantitative risk control, but the basic elements are there to describe a wide range of investor goals.

Taken together, the three objectives seem very reasonable. But in practice, it is hard to get them—at least, with any sizeable exposure to equities (and bonds too at this point).

Why is this? For one, there is a natural tradeoff between the goals of providing downside protection and capturing risk premiums. When I first started looking at this issue, I didn’t understand why it is so difficult to add a risk budget or drawdown limit to a diversification framework. At some point, the incompatibility began to dawn on me.

If you try to impose a drawdown limit, it interferes with equilibrium. If you rely on equilibrium, it is never obvious how much downside there is. A gap seems to exist between modern portfolio theory and related mean-variance portfolios—which are great at capturing risk premiums over the long term but lack a risk discipline—and quantitative strategies that have great risk disciplines but are not so good at capturing risk premiums.

The question is whether it is possible to bridge the gap and at what cost? And if you try to find a middle ground between premium capture and risk control, how do you do it?

Imagine you are a trustee of an endowment, and the fund is down 10% for the year. You were hoping for a return of 8%, so now you’re off almost 20% from where you expected to be. You may have to start looking at spending cuts. You know that if the fund drops another 10%, it will threaten core functions. If the fund drops another 20%, it is difficult to think about what will happen. What do you do? Do you sell assets now to slow the rate of decline? Or do you hold on and hope for a rebound?

Institutions normally have a policy statement to guide trustees through this decision. The policy statement is a strategic plan written in anticipation of market ups and downs. Most encourage riding out the rough times. As part of maintaining the strategic allocations between asset classes, most recommend adding to underperforming assets during a downturn. The plan realizes that rebalancing involves doing the opposite of what most people will feel like doing. For instance, if the equity market is declining, instead of selling equities into market weakness, the plan tells you to maintain the proportion of equities to fixed income. That means buying more equities. However, buying more equities actually accelerates the losses if the market continues to go down.

According to equilibrium models, this makes sense because it is the best way to capture risk premiums. When the market recovers, or restores equilibrium between asset class valuations, you make more by having bought the cheaper asset. But it is not the best way to provide downside protection.

Objective 1. Some Downside Protection

The Harvard experience during the financial crisis is particularly important, as described in this press release:

  • Harvard Endowment Hires New Chief Investment Officer, January 14, 2010
  • Boston – Harvard University named a new CIO after the school’s endowment dropped $26 billion last year. Long admired for its investment savvy, Harvard was forced into heavy cost cuts and interrupted its high-profile campus expansion.

I think what happened at Harvard happened to a lot of institutions and people. At some point, losses get too heavy and there is nothing you can do other than start hoping for a turnaround. Once you are down 20%, it seems too late to start managing risk. Instead, you start reminding yourself of deeply held beliefs such as “don’t time the market,” “buy on the dips,” and “think long-term.”

Harvard has been at the center of academic theory and practical implementation. It has taken modern portfolio theory to its limits, and most of the time it has paid off. However, sometimes the only way to avoid a 30% loss is to start doing something about it when you are only down 5% or 10%.

Objective 2. Capture Risk Premiums in Line with Risk Tolerance

In trying to explain why many portfolios lost more than the worst-case outcomes predicted by asset allocation models, one researcher looked at how much risk is really in a mean-variance portfolio. He modeled portfolios under stress using a typical correlation matrix. Then he compared the predicted performance to the actual performance of these portfolios in market crashes. The two weren’t even close. So he tried it again, this time using a correlation matrix built from information about asset behavior during prior market crashes. This time, the results matched almost perfectly. The problem was the way the correlation matrix was estimated, using average rather than stress relationships.

Why doesn’t everybody use a correctly constructed matrix? Because it can mean cutting equity allocations by as much as 75%, and few funds are willing to do this. Especially now. Giving up the opportunity for equity risk premiums at a time when bonds are so highly priced might be more risky than doing nothing. If equity allocations are reduced, current low yields on fixed income will not support the promises of pension plans and other institutional sponsors that have assumed annual returns of 7% to 9% or the retirement income needs of many individuals.

Objective 3. Some Alpha Opportunities

Going after alpha opportunities is almost irresistible. The history of Wall Street is the history of story telling—whether it is an undervalued stock, a reversal in a trend, or a chart pattern—and nothing has changed. I love a good story too. It is part of being an investor and an optimist.

There are two interesting issues related to alpha. One, the Efficient Market Hypothesis (EMH), has been debated for decades. The other, idiosyncratic risk, seems to be fairly well accepted. EMH addresses the effectiveness of active management such as stock picking, compared to broad asset class exposure. In other words alpha versus beta. Probably more research has been done and material written on this topic than any other in investing. Tests of the EMH going back over 30 years have consistently shown that beating the market with either technical or fundamental analysis is tough. And if current hiring trends are any indication, then EMH is winning. Stock pickers are out; asset allocators are in. As Ennis says, it only works about half the time for most of us.

Idiosyncratic risk is non-diversified risk. The issue is whether or not you can expect to be compensated for taking this kind of risk. It is generally thought that the market only provides an extra return for taking an extra risk if that particular risk cannot be diversified away. If you want a credit risk premium, the market should reward you if you buy a diversified portfolio of bonds. However, it is not obligated to reward you if you buy one bond that turns out to be bad, such as Enron, Worldcom, or Greece. If you want an equity risk premium, the market should reward you if you have broad exposure to equities, not if you buy an individual company stock. In other words, theoretically compensated risk is diversified risk or beta risk, not alpha. Traders and quantitative investors understand this and therefore don’t rely on equilibrium or mean-reversion to protect them from losses. Because the nature of the risk is different, it makes sense to manage it differently as well.

The first step in moving forward for any investor is to find the right balance between seeking downside protection, capturing risk premiums and finding alpha opportunities. After finding a balance, strategy implementation is really an engineering problem. That is, the decisions about the kinds of investments most likely to meet the objectives and the trading rules to manage them. And to realize that in practice, the objectives often compete with each other.

For instance, if you want downside protection, you could interfere with the capture of risk premiums. If you want alpha, you shouldn’t expect to capture risk premiums or find any protection from equilibrium. If you want to capture risk premiums, how much downside protection can you really expect?

In terms of existing portfolio construction, I am not suggesting diversification models don’t add value—just to recognize what they can and cannot do. The most important decision is when and how to begin managing losses or mitigating volatility. If you don’t want to accept the possibility of large losses, then the strategy needs to manage risk actively so that losses are addressed earlier rather than later.

There are two ways of doing this. The first is to stay within the MPT/MVO framework by adding risk management features other than diversification (such as hedging and insurance) and to find securities that add real diversification when you need it most—during market crashes. The second is to go outside the diversification framework to add more dynamic quantitative elements.

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020