Risk Should Not Be Defined Solely As Volatility: Page

Risk Should Not Be Defined Solely As Volatility: Page
Photo by geralt (Pixabay)

Portfolio optimization continues to be a hot topic as investors, finally recovering from the global financial crisis, come to terms with its harsher lessons. The traditional view of a diversified portfolio having many different asset classes is giving way to the view that it’s more important to diversify risk factors, regardless of how the exposure to those factors is purchased.

Diversification among risk factors

“For asset classes, there is a jump in the average cross-correlation from 30% during quiet markets to 59% during turbulent markets. This rise in correlation comes primarily from the various equity and equity-driven asset classes. The well-known observation from this analysis is that asset class diversification tends to disappear when it is most needed: during periods of market stress,” writes PIMCO executive vice president Sébastien Page. “Investors are now realizing that asset classes are just ‘containers’ for underlying risk factors. Therefore, diversifying among risk factors directly may be more efficient than diversifying across asset classes.”

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Page compares risk factors to macronutrients (fat, carbs, protein): no matter how diverse your diet is in terms of food choices, if you get too many carbs and too little protein you won’t be healthy. Similarly, he sees asset allocation as a tool for achieving risk factor allocation, not an end unto itself.

While this goes against traditional asset construction techniques, it doesn’t contradict what has really worked in the past.

Use of Sharpe ratio

“Investors like to use the Sharpe ratio,” writes Page. “But it is becoming evident that minimizing exposure to large losses, or ‘tail risk,’ is what really matters. After all, large and permanent losses are ultimately far more relevant to the investor than transitory swings in valuations.”

This is exactly what successful value investors have done, to great effect. The most famous example of course is Warren Buffett, and recent research has reached the same conclusion as Page – Buffett isn’t rich because he has maintained such a high Sharpe ratio, but because he has patiently accumulated value for fifty years while avoiding major setbacks. In fact, Page cites a hypothetical investment strategy developed by Andrew Lo that has a Sharpe ratio double the S&P 500 (INDEXSP:.INX) average and reduces volatility measured by the standard deviation of returns, but it increases tail risk significantly. Following the strategy gives a good chance of earning strong returns in the short run while increasing the odds of getting wiped out down the road.

“Risk should not be defined solely as volatility; investors should seek to explicitly measure and manage tail-risk exposures,” Page concludes.

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