Over the last several months I have written frequently in this column about the need for downside market protection as part of a well-structured portfolio. Over those same months stocks prices have continued to reach new highs in a remarkably low volatility environment. In retrospect my advice might seem poor as hedging against downside market movement might have meant giving up short-term gains as the market has continued to advance higher in price. With hindsight I would again make the same recommendation.
Part of prudent portfolio risk management is a quantitative assessment of risk versus reward.
There is a difference between taking blind risks and taking calculated risks. Taking blind risk involves good fortune. Calculated risks are taken based upon the probability of loss versus the probability success. The degree of loss and the degree of success must be part of that calculation.
Over the last several months my assessment of market risks has been that there is a rising probability of a substantial stock market correction to the downside. Prudent risk management would therefore dictate that it is wise to protect against that risk at the potential expense of giving up some short-term gains. In other words, I am willing to forgo some gains to insure against substantial losses.
While it is most appropriate to structure a portfolio such that returns are consistent over time, meaning that a portfolio should most often if not always have some protection against downward market movement, it is appropriate to adjust the amount of downside protection based upon the probability of adverse market movement.
However, probabilities are rarely 100 percent; therefore, you must be willing to accept less than optimal portfolio performance when lower probability events happen.
Naturally, some people would say that my view of the stock market is overly pessimistic. In other words I assign too high of a probability to a substantial stock market correction. That remains to be seen.
What is proven is that in the long-term investors do not earn the average annual long-term return of the stock market; a poor assumption that is frequently used in retirement planning. In the long-term investors earn actual annual returns. As a matter of math, actual cumulative annual returns have been less than cumulative average annual returns. Negative return years are to blame.
This means that prudent portfolio risk management is to protect against substantial portfolio losses at the expense of potentially giving up small short-term gains. This is the environment that I believe we are currently in.
Portfolio risk management requires a disciplined approach. In other words you must be willing to accept losses at times because low probability events do happen. However, over time managing toward higher probability events means long-term success.
In conclusion, future events and market movement cannot be known for certain. However, in the view of the author markets are increasingly at risk of a substantial correction to the downside. Now is the time to protect against those downside risks with the understanding that this also means there is some risk of foregoing upside gains.
Nielsen has worked in capital markets for over 20 years with a focus on fixed income portfolio and risk management. He has an MBA from George Mason University and holds the Chartered Financial Analyst designation. He currently works for Opportunity Bank of Montana.
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