Dynamic Advisor Solutions: Risk Management Keeps Evolving

(Dynamic Advisor Solutions) Is the 60/40 portfolio dead? This question has been coming up a lot lately given historically high valuations for the stock market and historically low interest rates for the bond market, leading to relatively low return expectations for the future.

But that question is flawed in that it assumes all 60/40 portfolios are created equal and that all stocks and bonds have the same level of risk. Here, we evaluate how portfolio risk measurement and management have evolved over time and how to better position portfolios for specific client needs.

Evolution of Portfolio Risk Measurement

Stage 1: Stock-To-Bond Ratios. This is where it all began, the original measurement of risk in a portfolio. It is well liked and heavily utilized because it’s easy to understand and explain. But there is a key fundamental issue with stock-to-bond ratios: They assume that all stocks have the same risk and all bonds are risk-free. Both are false assumptions. 

  • Equities: Small-cap stocks will generally have more risk than large-cap stocks and similarly, emerging markets stocks typically have higher risk than stocks in developed markets. The actual risk within equities depends on the unique asset class mix selected and the amount allocated to each asset class. 
  • Fixed income: Broadly speaking, the only risk-free asset is cash. All bonds have some level of risk. But corporate bonds, including low quality high yield bonds, could have significantly more risk than treasury securities issues by the U.S. government. Similarly, longer duration bonds will have higher risk than those with shorter maturities.

Given this information, the typical 60/40 portfolio may be taking on more risk than may be expected. This could come as a shock to investors in a significant down market or a bout of heightened volatility, leading to unwanted investor behavior such as market timing or exiting the market altogether.

 Stage 2: Risk Scoring. Although not a new concept, risk scoring started to gain popularity after the Global Financial Crisis of 2008, in which many investors were surprised and adversely impacted by the amount of risk in their portfolios. Risk scoring is an enhancement to stock-to-bond ratios in that it measures market risk of each asset class individually as well as at the portfolio level.

  • Asset class risk: There are a lot more asset classes than just stocks and bonds and it’s important to understand the unique risks inherent in each one. The easiest way to understand and anticipate risk is to measure it relative to a common benchmark. The most common forms of risk measurement are beta, standard deviation (aka volatility), correlation and some form of downside risk (such as maximum drawdown). Measuring risk relative to a common market benchmark, such as the S&P 500, allows an apples-to-apples comparison of risk across all investment options. 
  • Portfolio risk: It’s not enough to simply measure the risk of all asset classes and investments utilized in a portfolio; you also need to evaluate how the included securities interact with each other. Combining uncorrelated assets in a portfolio helps reduce overall portfolio risk (aka diversification) and it’s important to understand how those relationships impact the overall portfolio risk profile in various market environments.

By measuring risk at the security and portfolio level, portfolios can be constructed to a vey specific risk target. When investors with a specific risk tolerance are matched with a portfolio that behaves as expected, they’re more likely to stay invested and have a better chance to reach their long-term investment goals.

Evolution of Client Risk Measurement

Stage 1: Ability to Take On Risk. The original view of an investor’s risk is simply their ability to do so. When would you like to retire? What percentage of total assets is invested? How much income will be needed? These are questions a robot would ask to get the most efficient answer. But they ignore the human element of an investor’s capacity to bear risk—also known as emotion. If an investor is not comfortable with their risk level, it opens the door for irrational, knee-jerk reactions at the detriment of long-term portfolio objectives. 

Stage 2: Willingness to Take On Risk. Again, nothing new. Again, more emphasis post 2008. The willingness to take on risk is a behavioral finance topic and addresses the many different behavioral biases that we instinctively have as humans. What is your tolerance for market volatility? How much in total losses would you emotionally be comfortable with? Are you behaviorally tilted more toward risk or return? Notice that these questions may not have a simple answer, but they are no less important than the more objective questions related to ability.

Only through the evaluation of both ability and willingness to take on risk are we able to get a true gauge of an investor’s risk tolerance. Getting a more accurate measurement of risk—at both the investor and investment levels—allows for enhanced matching of performance and expectations, leading to better investment outcomes.

Evolution of Strategy Design

Stage 1: Decreasing Risk Through Life Stages. The most traditional portfolio design utilizes the same asset classes but shifts the allocation from higher risk to lower risk to align with an investor’s risk target. In the early years, an investor will allocate to a higher risk portfolio, and will slowly de-risk throughout their life. This simple approach has been implemented for decades and makes intuitive sense because your risk tolerance should decrease as you near retirement. But is it too simple? There are many variables, unique situations and behavioral biases that can develop at various stages of life. Is the same strategy appropriate at each stage? 

Stage 2: Selecting the Right Strategy at Each Life Stage. Can choosing the right strategy at various life stages improve an investor’s outcomes? Let’s look at some examples by evaluating the four key life stages.

  • Getting started: An investor is starting their career and are able to invest more of their earnings into higher risk, growth-focused portfolios. Perhaps it may be appropriate to allocate to more granular exposures, such as sectors and industries with higher growth potential.
  • Building years: An investor is buying a house, starting a family and thinking more about their nest egg. During this stage, there is a higher capacity to save and invest with a more balanced approach. A more actively managed strategy may be appropriate, providing the ability to maximize opportunities in various market cycles.
  • Stability: An investor in near retirement and more concerned with preservation of capital. At this stage, a strategy more focused on protecting to the downside while still taking advantage of upside opportunities may be favored.
  • Retirement: An investor is primarily interested in a more conservative approach in their investments and stable income generation. At this stage, a more income-focused portfolio within both stocks and bonds may be beneficial to support distributions.

 

As an investor progresses through their life stages, a combination or risk reduction, as well as selecting an appropriate strategy, can help improve their investment experience and reach their long-term goals.

Whether it’s technological or financial, evolution is happening all around us. It’s important to adapt to these changes to benefit investor outcomes.

Konstantin (Kostya) Etus, CFA® is Head of Strategy for the Investment Management team at Dynamic Advisor Solutions dba Dynamic Wealth Advisors. He has experience in asset allocation and security selection of ETF and mutual fund portfolios, including specializations in ESG investments, international markets and 529 plans. Etus is a Chartered Financial Analyst (CFA®) and holds a Master of Investment Management and Financial Analysis and Master of Business Administration from Creighton University. 

Investment advisory services are offered through Dynamic Advisor Solutions, LLC, dba Dynamic Wealth Advisors, an SEC registered investment advisor. This material has been distributed for informational purposes only and not advice relative to any investment or portfolio offered. All investments carry certain risk and there is no assurance that an investment will provide positive performance over any period of time. Past performance is not a guarantee or a reliable indicator of future results.

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