Risk - Measure It and Manage It

Many people talk about risk, but don’t know how to measure it.  How do you measure risk?  At THOR, while we consider many risk metrics, there are three key risk components on our radar.  First and foremost is the risk of permanent loss of capital.  The second important risk consideration is the price paid for an investment.  The third risk we consider is the price volatility of the portfolio.  One way of measuring price volatility is to look at the beta of a portfolio.  Beta measures how correlated a portfolio’s price movements are compared to the market.  The market’s beta is 1.00.  If a portfolio is riskier than the market, as measured by price movement, the beta will be greater than one.  If the portfolio is less risky than the market, the beta will be less than one.

With those risk considerations in mind, let’s take a look at two hypothetical portfolios.  One portfolio experiences 40% more price volatility than the market while the second portfolio experiences 40% less price volatility than the market.  The portfolio with more risk has a beta of 1.40 while the less risky portfolio has a beta of .60.  Here is an example of the returns each portfolio could produce over a 5 year period:

In good markets like year 3, the higher beta portfolio performs very well.  In poor performing markets like year 4, the higher beta portfolio performs significantly worse than the market.  An investor needs to ask: “Is the higher return of approximately 0.4% annualized in the higher beta portfolio worth the increased dispersion of returns experienced with 40% more volatility than the market?”  With US large-cap stock valuations at historical highs, this is a time when a prudent investor should be looking to lower beta in their portfolio, not increasing it.

What does this mean for your portfolio?

As an active manager of our clients’ portfolios, we will increase or decrease risk based on fundamentals and our proprietary investment models.  There are times when we add more risk in our clients’ portfolios such as at the end 2008 and times when we have reduced risk like the tail end of 1999 and the present time.  We are reducing the beta of our portfolios today in 3 ways: 1) We have a lower exposure to equities than our target objective; 2) We have an overweight position to assets that are non-correlated, which means their price movements are not dictated by what happens in the stock market; and 3) In our equity investments, we are invested in areas that have a higher economic margin of safety.  These are investments we believe have more upside potential in comparison to downside risk.  History tells us that these attributes tend to hold up better in down periods.  Actively managing the risk of a portfolio is imperative today as investors have become complacent and forgotten that market corrections are the norm, not the exception.