What does the word “risk” mean to you? In asset management, risk is commonly defined as standard deviation, or how much an investment’s returns vary from its mean return. However, I often find clients don’t think of risk in those terms, making some conversations difficult. Instead, many investors equate risk simply with losing money. The question then becomes: “Is there an alternative measure that can help clients better understand and therefore more appropriately manage risk?” One such measure is upside/downside capture.
The concept of upside/downside capture is fairly simple. “Upside” is defined as periods when the market earned positive returns, while “downside” refers to periods when the market earned negative returns. “Capture” indicates how much an investment participated in the market return. All else equal, it is considered desirable to capture more than 100% of the market’s upside (increase more), and less than 100% of the downside (decline less).
One strategy that has been appealing when it comes to capturing less market downside is minimum volatility1. Minimum volatility is designed to reduce risk, while maintaining 100% equity exposure. Why is this important? Humans tend to experience the pain of losses more than the joys of equivalent gains, a bias known as “loss aversion.” Loss aversion is one reason many investors closely identify risk with losing money, rather than its true definition of standard deviation. This bias can result in impulsive (and likely bad) decisions when the value of their portfolio decreases. For example, due to fear of loss, many investors pulled their money out of the market in the fourth-quarter turmoil of 2018 only then to miss the market rally in early 2019. Minimum volatility strategies may help prevent these negative impulsive investor actions by reducing risk in a manner that resonates with investors–encouraging them to stay invested in periods of market stress and helping to keep them on track toward their long-term financial goals.