Prepared For Anything
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“The only thing we can be certain of in this life is that we can be certain of nothing.” – Albert Einstein.
Incorporating a wide variety of portfolio risk mitigation techniques is essential to address unforeseeable macroeconomic challenges.
It is nearly impossible to properly identify and quantify risk. Common risk factors in the realm of investing and portfolio management may include:
1. Volatility of returns;
2. Portfolio concentration/diversification;
3. Asset correlations;
4. Valuations; and
5. Sensitivities to external factors (e.g., interest rates).
This year has been a stern reminder of the importance in accounting for a wide variety of risk measures in a portfolio.
But many equity investors choose to disregard defensive tactics for a variety of reasons.
Defensive measures will generally cause portfolio performance to lag during bull markets. As an example, if one has cash in a portfolio, the likelihood of underperformance rises as the market gains.
Disregarding traditional economics
Many investors will cast aside economic theory when it does not play into a bull market narrative. In the past decade, for example, many were convinced that inflation and interest rates could remain low in perpetuity.
The desire to pursue instant gratification drives investors to focus on elevated short-term returns. Therefore, many who intend to invest for the long term still focus on short-term merits (i.e., quarterly earnings or media reports).
Common behavioral biases
Most investors subconsciously let certain biases influence investment decisions. Some include confirmation, familiarity, and recency biases. Many of these biases prevent investors from clearly analyzing a given investment and the corresponding risks.
During equity bear markets, as in 2022, many investors wished they had proactively and carefully positioned their portfolio in a more defensive manner – to have taken better precautions while the opportunity was ripe. Some of these precautions may have included: holding a large cash allocation, owning more non-correlated sectors of the economic cycle (materials, healthcare or foods), or sticking with a conservative approach to purchasing assets (i.e., value vs growth).
Cash is king in bear markets
Why was the greatest long-term investor, Warren Buffett, sitting on approximately $150 billion in cash and equivalents at the beginning of 2022? Had he lost his stock-picking prowess?
His buildup of cash reflected his keen attention to risk management.
Cash is a critical asset when it comes to risk mitigation and capital preservation. Although cash will lose purchasing power in an inflationary environment, it serves multiple purposes in a risk-conscious portfolio because it:
1. Keeps a portfolio liquid and versatile;
2. Is uncorrelated with major asset classes; and
3. Will generally not lose more than the rate of inflation.
In 2022, as most major asset classes have faced immense pressure, the value and utility of cash become more evident. While the intrinsic value of a dollar has lost purchasing power, cash has continued to outperform many equites and fixed income assets.
As individuals and families require “rainy-day funds” to withstand uncertainty, that concept should also apply to a portfolio. In times of shock and market turbulence, one is in an advantaged position with cash on hand as it can be a powerful tool in generating strong risk-adjusted returns.
The concept of diversification is well-known but often misunderstood. Simply, it is the aggregation of different asset types, industries, geographies, or investment styles to ensure that no one asset category adds undue risk to the broader portfolio.
But if an investor ignores exposure to varying macroeconomic environments and correlations within a portfolio, perceived diversification may be ineffective. For example, the S&P 500 is sometimes thought to be a diversified equity index. However, as its constituents are market-capitalization weighted, it can become overly concentrated in a handful of companies and/or sectors. That has been the experience in the past decade. As large-cap-growth companies grew decisively bigger, they added more weight to the index. Consequently, the technology sector was heavily weighted in the S&P 500 index, while sectors including energy and materials had negligible weight. In 2022, when most equity market sectors have incurred significant losses, the energy sector thrived.
Rather than focusing on the number of securities in a portfolio, one needs to understand the purpose of each asset within the portfolio and their susceptibilities to different external factors. In an equity portfolio, for example, not all stocks should serve the purpose of generating high returns. Instead, each asset should be measured given its prospective risk and reward contributions to the broader portfolio.
Valuation as a risk mitigator
Many consider value investing to be the approach of buying companies trading at significant discounts (e.g., low price/earnings ratios.) Less appreciated may be the benefit of value investing as a risk management tool.
1. Value investing might necessitate higher cash holdings during unsustainable bull markets
Bull markets lead to higher average valuation multiples. As equities become more expensive relative to historical valuations, it becomes more difficult to identify quality companies that trade at reasonable valuations and produce favorable long-term returns. As the equity return prospects become scarcer, it may be harder to become fully allocated to equities. Thus, investors might be incentivized to keep cash on the sidelines.
2. The less one pays for an asset, the lower the asset risk
When one purchases an investment asset, one should have determined if the price made sense given the benefits of the asset. In traditional value investing, investors aim to acquire companies that trade at a market price well below perceived intrinsic value. This process is referred to as a “margin of safety,” as famously introduced by Ben Graham. The less one pays for an asset relative to its intrinsic value, the more the downside is protected.
The combination of ample cash and owning equities with a sizable margin of safety can serve as key tools for risk mitigation in all market environments.
Behind the curve
Generally, when an investor is disproportionately allocated to riskier stocks and sectors, they fall behind the market curve in addressing defense. The cost to shift to defense becomes more expensive.
In recent months, for example, investing in inflation hedges, low beta and dividend stalwarts have intensified, making those tactics less useful in achieving the desired portfolio risk mitigation.
The key to successful risk management is three-fold: measuring and accounting for all risk factors on both the asset and portfolio levels; the ongoing reassessment of evolving risks of individual assets and broader portfolios; and the proactive portfolio shifting to account for the adjusted risk landscape.
Defense is the new offense
The best offense (to generate long-term returns) starts with an effective defensive strategy. Before prioritizing investment returns, one must properly manage cash, ensure broad diversification, and invest in assets trading well below intrinsic value.
Joseph Caplan joined Caplan Capital Management, a New Jersey-based investment management firm, in January 2020 to focus on portfolio management and investment analysis.
The views presented are those of the authors and should not be construed as personal investment advice or a solicitation to purchase or sell securities referenced in this market commentary. The authors or clients may own stock or sectors discussed. All economic and performance information is historical and not indicative of future results. Any investment involves risk. You should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice. All information is obtained from sources believed to be reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or from the results obtained from the use of such information.