Strategic Risk Management

“How can you make your investments resilient enough to withstand financial storms like market crashes or a global pandemic?”

1. Diversify with Trend-Following Strategies

Trend-following is an approach designed to catch the momentum of rising and falling markets. By dynamically shifting investments—buying when markets rise and selling when they drop—investors can capture gains while reducing risk during downturns. This strategy isn’t limited to stocks; it can extend to a broad range of assets like bonds and commodities for maximum diversification.

Research shows that trend-following strategies have consistently delivered strong results over the past five decades. For instance, in markets where government bonds surged while stocks fell, trend-following provided critical downside protection. Ignoring this diversification in non-equity markets can reduce effectiveness.

Even with skepticism about momentum strategies' profitability, the evidence is robust. Diversified trend-following offers a proven way to generate "crisis alpha," or positive returns, during market upheavals.

Examples

• Trend-following protected portfolios during the 2008 financial crisis.
• Bond futures provided stability when equities collapsed.
• Diversification across commodities, stocks, and bonds balanced risks and returns.

2. The Goal Isn’t Perfection but Crisis Resilience

A portfolio that’s completely immune to crises is an unrealistic goal. However, building one that withstands unexpected shocks is achievable using a mix of techniques. Tools like one-month S&P 500 put options and dynamic strategies such as momentum investing can provide significant protection.

Keeping costs manageable is vital. Passive hedging, like holding credit protection, is often expensive. On the other hand, adaptive strategies like time-series momentum can protect investments while controlling expenses during calmer periods.

The trade-offs between reliability during crises and costs in normal times make it important to tailor your approach. Mixing passive hedges with adaptive strategies creates a crisis-resilient portfolio that balances safeguards with expenses.

Examples

• Treasury bonds are a go-to “safe haven,” though they don’t always excel during crises.
• One-month S&P 500 put options are useful but costly for small investors.
• Time-series momentum produced long-term gains, even during unstable periods.

3. Volatility Targeting Controls Risk

Volatility targeting is a method designed to keep portfolio swings in check by staying at a consistent risk level. It adjusts leverage based on changes in market volatility, offering stability during tumultuous times. The strategy works because volatility tends to persist over time—and often moves in the opposite direction of stock returns.

This approach takes deliberate steps to reduce leverage when markets grow turbulent and increase it when volatility drops. By managing these shifts, investors gain protection against surprises while improving risk-adjusted returns.

Removing the wild highs and lows smoothed out portfolios during crises like the pandemic, lowering drawdowns and decreasing extreme price changes. Volatility targeting doesn’t just manage risks; it can also soften the overall ride of the investment journey.

Examples

• Reducing leverage during the COVID-19 crash minimized significant losses.
• Increasing exposure after a price drop helped recovery when volatility eased.
• Balanced portfolios saw improved stability using volatility targeting.

4. Strategic Rebalancing Adds a Risk Buffer

Strategic rebalancing improves upon traditional rebalancing by incorporating smarter timing and broader diversification. While routine rebalancing aims to maintain asset allocation, it may backfire during prolonged market slumps for specific asset classes.

This approach takes into account market trends and cash flows rather than relying on rigid schedules. It may involve delaying rebalancing during downturns or even using those same downturns to buy into assets at lower prices. Adding exposure to global assets and broad trend strategies further strengthens the portfolio’s defenses.

The result? Strategic rebalancing keeps portfolios from drifting into imbalanced mixes while turning market slumps into opportunities for managing drawdowns.

Examples

• Long stock market declines punished traditional monthly rebalancing techniques.
• Using stock-bond trend data improves timing on allocation adjustments.
• Global diversification added another layer of portfolio protection.

5. Address Drawdowns with Pre-set Limits

Drawdowns—peak-to-trough declines in portfolio value—quantify downside risk and require careful management. Mistakes, like retaining underperforming investment managers for too long or firing successful ones too soon, can erode returns.

Setting pre-defined drawdown limits helps mitigate risk. These limits can trigger automatic responses, such as reducing exposure or replacing a fund manager underperforming relative to benchmarks. It ensures managers act prudently, knowing their actions will be evaluated under clear rules.

Drawdowns remind us of the human element in investing—where emotions and indecision can compound losses. Establishing rules removes guesswork, ensuring portfolios remain protected.

Examples

• A drawdown of 20% triggered automatic reallocations to reduce further losses.
• Consistent manager reviews kept ineffective teams from dragging portfolios down.
• Time-varying rules adjusted drawdown thresholds as market conditions evolved.

6. Balancing Systematic and Discretionary Approaches

Two key management styles dominate professional investing: systematic (rule-based algorithms) and discretionary (human decision-making). Both have unique strengths, and combining their features can create well-rounded strategies.

Systematic approaches excel in data-heavy environments, utilizing tactics like portfolio diversification and backtesting. Discretionary methods shine in areas like market sentiment analysis or tailored investments. Understanding these differences can help investors choose strategies best suited to their goals.

While some investors favor one approach over another, history demonstrates comparable effectiveness. Aligning the strengths of both methodologies allows for flexible, holistic management.

Examples

• Backtesting algorithms identified trends systematic strategies could exploit.
• Discretionary managers responded swiftly to unique pandemic-triggered factors.
• Mixing both allowed portfolios to thrive in varied market conditions.

7. The Pandemic’s Risk Management Test

The COVID-19 crisis became the ultimate stress test for modern risk management strategies. Those relying on advanced techniques like trend-following and volatility targeting outperformed traditional investments during the market’s severe downturns.

Allocating to strategies like long-short equity with focus on quality produced "crisis alpha." Volatility targeting reduced drawdowns across equity and credit exposures. Strategic rebalancing, particularly conditional approaches, performed better than outdated calendar-based models.

The crisis showed that integration of investment and risk management adds resilience. Traditional metrics fell short of guiding effective responses to unexpected events.

Examples

• Trend-following funds gained ground when equities plummeted in March 2020.
• Volatility targeting portfolios saw lower losses compared to standard ones.
• Conditional rebalancing delayed actions during downtrends, increasing returns.

8. Build for Positive Convexity

Positive convexity strategies, like trend-following and long-short equity, aim to create asymmetric returns. These strategies thrive during crises, capturing gains with minimal added risk.

By focusing on quality investments and profitability metrics, these strategies cushion downside shocks while participating in upside momentum. This balance aids portfolios navigating unpredictable market conditions, as demonstrated during the pandemic.

They are a reminder that embracing adaptation pays off. Investments focused on growth during good times and safety during bad times can effectively balance long-term goals.

Examples

• Quality-focused long-short equity funds excelled during the COVID-19 collapse.
• Profitable companies outperformed speculative ones during volatile periods.
• Implementing convexity strategies reduced losses across diversified portfolios.

9. Integrative Risk Management Trumps Silos

Separating risk and investment strategies creates disjointed results. Instead, integrating the two offers a cohesive plan for handling market challenges. Blending tools like volatility targeting with investment decisions reduces the chance of misaligned efforts.

The pandemic validated this integrated framework. Portfolios that merged investment and risk techniques delivered stronger performance as they adapted to the extreme conditions in real-time.

This philosophy pushes investors to treat risk as more than a separate function. It’s an innate part of the investment process, smoothing returns and tempering surprises.

Examples

• Combining trend-following with strategic rebalancing improved outcomes in down markets.
• Integrative planning reduced reliance on outdated standalone risk metrics.
• Portfolios with holistic frameworks bounced back faster during 2020.

Takeaways

1. Use trend-following and volatility targeting to make your portfolio adaptable to changing market conditions.
2. Mix passive and dynamic strategies, focusing on resilience rather than perfection.
3. Embrace tools like strategic rebalancing and pre-set drawdown rules to balance risk and returns effectively.