Risk Management

Mitigating Risk: The process of allocating a portfolio should be based entirely on mitigating risk. Risk is most often associated with the amount you could lose, or the downside. But there should be an equal emphasis on managing upside risk. In fact, there is often more upside than downside risk inherent in the market, as it tends to rise over the long-term. This explains the tendency for many investors to hedge only against upside risk by allocating fully towards long equity and fixed income positions, leaving little cash on the sidelines.

But sometimes there is significantly higher risk to the downside than there is to the upside. The level of exposure in one’s portfolio should depend on the anticipated (and potential unanticipated) risk in the market place.


Upside vs. Downside Risk: A portfolio that is comprised entirely of cash, for example, is hedged 100% against downside risk. This portfolio will not experience any draw downs or losses during market corrections. On the other hand, this portfolio will not participate in any market gains and is, therefore, exposed to unlimited upside risk. Conversely, a portfolio that is fully invested in the market is hedged 100% against upside risk. This portfolio will experience significant gains during rally’s, but is also exposed to unlimited downside risk. A portfolio should be positioned to hedge against both types of risk.

An investor’s conviction in the marketplace determines the type of risk that he or she believes is being managed. For example, if the SPY is in deeply oversold territory and sitting below the lower Bollinger Band, the risk to the upside is likely far greater than the risk to the downside. During a situation like this, it makes sense to increase upside hedges (more aggressive, shorter-term positions) and decrease hedges (cash, puts and conservative positions). The opposite is also true. Near the higher-end of the valuation range, a portfolio should be shifted away from aggressive positions and towards cash and conservative positions (downside hedges).

When it is unclear whether there is a higher level of risk to the upside or downside, both conditions should be hedged against. Portfolio allocation should constantly be shifting based on the level of risk at any given time.


Mitigating Upside/Downside Risk: Let’s take a look at what types of positions hedge against these two forms of risk.

  • Cash positions mitigate risk to the downside, as it experiences no draw downs or losses during market corrections. Cash should not be viewed as asset with no return on capital. Instead, it should be viewed as an option, allowing an investor to purchase securities at substantial discounts during volatile markets. In effect, it allows an investor to leverage short-term trades when values are depressed. Having cash gives an investor the necessary flexibility to capture opportunity when it is confronted – a key advantage when investing.
  • Longer-term, conservative positions also protect against the downside. First, conservative (i.e. lower-strike options) positions typically see significantly smaller draw downs than aggressive (higher-strike option) positions. This is because investor sentiment is typically very low during corrections, and the price of out-of-the-money options fall much more quickly than in-the-money options. Secondly, a longer-term position affords an investor more time to see his or her thesis through to fruition. For instance, the financial crisis in late 2008 lasted only six months and was followed by a dramatic rally. An investor holding a longer-term conservative position would have likely done well with those holdings. Shorter-term positions, on the other hand, likely closed worthless.
  • Longer-term, conservative positions protect against upside risk, too. These positions gain value, but at a much slower rate than shorter-term aggressive positions do, during rallies.
  • Shorter-term, aggressive positions hedge entirely against risk to the upside. These positions gain significant value quickly during rallies. As investor sentiment becomes more bullish, out-of-the-money options increase in value as potential buyers bid up prices in an attempt to avoid “missing the train.” Conversely, during corrections, these positions lose significant value.

It is very important to understand that portfolio allocation is largely dependent on hedging against both upside and downside risk simultaneously.


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