INVESTED: In Markets, in the Future, and in Society.

What’s the Downside?

Investors should be familiar with the concept that risk and returns go hand in hand. Generally, to be able to expect higher levels of return, one must take on more risk. However, unlike return which is easily quantified in terms of dollars or percentages, risk is a relatively vague term. Oftentimes, investors and investment professionals alike are purposefully vague about the concept of risk, since the topic is more easily avoided than quantified. However, we’d argue that defining, understanding, and managing risk is the thing that defines investing.
 
So, what is risk then? Is it any level of loss? Is it not achieving your return target? Is it general uncertainty about the future? Risk is all the above, and it also depends on the particular circumstances of an investor or institution. A couple of years ago, I wrote on this concept in a blog post and explored the fact that in most cases there is no ‘one-size-fits-all’ optimal portfolio. This blog post defined various investor objectives and constraints and defined different portfolio choices with varying risk and return metrics. The common and simple measure of standard deviation of return was used to define risk; Monte Carlo simulations were utilized to estimate the probability of each investor achieving their respective objectives based on the portfolio they invested in. The outcome was that no individual portfolio was superior for all investors, and the differing objectives and constraints led to investors preferring different portfolio options.
 
More recently, the CFA Institute published a blog series on the importance of clearly defining and communicating objectives and defining risks. In the CFA’s third installment of the series, they introduce a similar (yet more robust) concept built by researchers collaborating in a 2019 paper: it takes the probabilistic quantification of risk a step further by using a combination of shortfall risk and maximum loss tolerance. This framework particularly applies to institutions and individuals that have cash flow needs, making the path of returns more important than the terminal value alone. Reducing the overall portfolio drag caused by volatility should always be a consideration for investment decision makers. But in these cases, reducing downside exposure becomes increasingly important to ensure the portfolio’s ability to fulfill the needs of the beneficiary doesn’t become impaired. Adding exposure to strategies that have downside management techniques such as tail hedges, trend following, and dynamic leverage can increase the overall utility of investor portfolios in this multi-objective risk framework. This ultimately allows investors to better customize their investments to fit their needs.