Good Portfolios Embrace Risk

Robert J. DiQuollo, CFP, CPA

How some investment managers are designing portfolios for normal, bear, and "crash" markets by including several layers of risk management.

several layers

With investors still wary about the markets and the economy, many are wondering about how to risk-manage their portfolios against sudden declines or protracted bear markets. In light of these concerns, portfolios should include of risk management, each designed to address — and mitigate — different aspects of risk arising from different market scenarios.

normal markets, protracted bear markets,

catastrophic crashes

As a physician with considerable assets at stake, you need risk management protection in and markets experiencing . There are a number of strategies to ask your advisor about.

normal

They determine appropriate market segment allocations in various economic environments. You will need rigorous rules to help you adhere to those allocations as markets move within each environment. In markets, this strategy helps mitigate losses resulting from volatility — and actually exploits this volatility — by imposing a systematic “buy-low, sell-high” discipline.

bear

These are designed to quickly identify trends in market segments, providing “sell” signals early during declines and “buy” signals early during advances. In markets, these strategies help avoid significant exposure to lengthy declines in specific sectors and the overall markets.

Proactive asset allocation and rebalancingDynamic momentum strategies

“Safety-net”

crash

This type of protection applies only in the event of a catastrophic market decline, and costs next to nothing to hold. In “” markets, this strategy benefits from the spikes in volatility that typically accompany such declines, while not creating a drag on portfolio performance during more normal market environments. But be careful — most of what’s available in the market, such as puts and collars, are not worth the cost.

Your approach

Not all risk management strategies are created equal. There are many products on the market that offer risk protection, but many are limited in the benefits that they provide. For example, the so-called black swan funds may protect against severe market declines, but these investments can have a significant adverse effect on a portfolio during normal — and vastly more likely — market environments.

And the problem with traditional hedges such as puts and collars is that, while they provide protection, they give up too much in return. For example, put options are expensive and, once the market recovers, they lose value. Collars, on the other hand, defray direct costs by giving up some potential future gains — not exactly what you want to do after a market downturn.

Robert J. DiQuollo, CFP, CPA, is chief executive officer and senior financial advisor at Brinton Eaton a wealth advisory firm in Madison, N.J., serving individuals and institutions throughout the U.S. Mr. DiQuollo is a member of the MD Preferred Financial Advisor Network. He can be reached at diquollo@brintoneaton.com.

A coordinated approach to risk management — one that provides coverage over a wide variety of market scenarios — provides the best opportunity to control losses and achieve market-beating returns. So, simply balancing risk and return may not be the primary consideration in building a portfolio. It may be finding an investment adviser who can expertly manage — and exploit — risk across a wide variety of changing market conditions.