The Pursuit of Risk Management

 In a Nutshell

Risk is unavoidable; it is part of life. There are known, unknown and unknowable risks. The best we can hope for is to undertake the pursuit of risk management, in order to minimize the impact to the best of our understanding and abilities.

-the probability and financial impact of a risk determines whether we bear it, reduce it, transfer/insure against it, avoid/remove it

-dimensions of risk include: death/disability/health, longevity, inflation, market/investment risk

-the dominant dimensions of risk are a function of an individual’s life-cycle; early in the life-cycle protection of human capital is most important, whereas approaching or in retirement protection of financial capital against market, inflation and longevity risk is most important

-risk control is pursued via: diversification, insurance and hedging

-diversification is less effective than in the past, due to globalization of the economy/communication/thought and likely the growing popularity of index investing

– insurance and hedging are rarely justified in a market context; they are too expensive to use continuously, and deciding when to selectively apply insurance or hedging is tantamount to market timing which is very hard to do successfully. Of course one must also keep in mind the counterparty risk that accompanies insurance and hedging

-Litterman: ““My advice to long-term investors is that the next time someone knocks on the door selling a tail-risk insurance product, they should ask for a two-sided market. Perhaps the opportunity is on the other side.”

-Montier: ““Tail risk protection appears to be one of many investment fads du jour. All too often those seeking tail risk protection appear to be motivated by the fear of missing out (not fear at all, but greed)” and “and in the end plain old cash is probably an under-appreciated cushion against bolts from the blue”

-Davis: “hedging comes at a price and their overuse (too much and/or for too long) can be a significant drag on performance”

-Grant: ““I kind of believe that the best way to reduce risk is to take things out of the portfolio, not add them”

-Bottom line is that: (1) insure against low probability very high personal financial impact items (death, disability, health/medical), (2) manage market risk by reducing your risky assets allocation to a level consistent with your risk tolerance, (3) manage inflation risk with: enhancing returns with risky assets, TIPS/RBBs, commodities, real estate and gold,  (4) manage longevity risk with: pure longevity insurance, annuities, proportional withdrawal strategies, (5)focus on the precious few things that you can actually control: savings rate, spending rate, investment costs and asset allocation.


1.0- Background

2.0- Risk management- Approaches

3.0- Dimensions of risk

3.1- Death/disability/(US)medical-health are naturals for insurance

3.2- Longevity risk (i.e. the risk of exhausting assets before death)

3.3- Inflation risk

3.4- Market (or investment) risk

3.4.1- Diversification

3.4.2- Hedging market exposure based on/and with VIX

3.4.3- ALM (Asset Liability Mgt) or LDI (Liability Driven Investing)

3.4.4- Insurance for Market Risk

3.4.5- Hedge or insurance costs rarely justified (for market risk)

4.0- Other risk management approaches

5.0- Bottom Line


1.0- Background

As a measure of the state of the art in risk management, just consider last week’s announcement by JPMorgan that they lost $2B (and perhaps ultimately more) in transactions designed to manage their risk; and JPMorgan was the only major bank that made it through the 2008 crisis without significant losses, its CEO Jamie Dimon is considered one of the smartest risk managers on Wall Street and JPM was believed to have possessed the crème-de-la-crème of banking industry’s risk management technology and expertise; Mr. Dimon has also been leading the banks’ anti-Volker rules movement, the rules that would restrict banks from gambling with depositors’ money and using a safety-net paid for by taxpayers.  In an earlier blog on the subject of risk “Risk Perspectives”, I  promised a follow-on blog on Risk Management; this blog, somewhat longer than I had hoped for and less satisfying in its conclusions, is the fulfillment of that promise. That earlier blog concluded with some thoughts on the difficulty of defining and measuring risk. Definitions of risk range from the mathematically convenient but not very meaningful, to perhaps meaningful but mathematically intractable; forcing one to think in terms of something simple like not being able to meet one’s objectives. Volatility doesn’t cut it; neither as a definition, nor as a measure, of market risk. And market risk is just one of many dimension of risk. A more meaningful definition is the probability of something bad (e.g. a shortfall) happening multiplied by the size of the shortfall.

Types of risk range from known-unknowns (measurable risk like roll of a die) to unknown-knowns (un-measurable risk like weather/hurricane/tornado) all the way to unknown-unknowns (Black Swans that we can’t even contemplate a priori). Unfortunately, only the known-unknowns category can be reliably modeled. So for most risk situations credible models are not available, parameters driving them don’t behave consistently over time (e.g. returns, standard deviations, correlations when considering market risk), and we are even unsure what might be the appropriate independent variables to consider (e.g. asset classes or risk factors). It’s also no surprise that markets are so difficult to model, since unlike inanimate things for which physics might be appropriate (but even there not very useful, as in hurricanes), behavior of markets is heavily influenced by human behavior. Unfortunately, in order to derive predictive value from risk models, you need credible models; and the state of risk modeling is considered by some to be an art and by others sorcery.

Another risk categorization is that based on its dimensions; these include: death, disability, market/investment, inflation, longevity and many others. The most relevant dimensions to each individual are a function of one’s life-cycle stage. For example, for younger individuals early in their work careers protection of their Human Capital against death and disability is most important, whereas inflation, longevity and market risk are most important in the near- or in-retirement stage of one’s life-cycle, when Financial Capital is predominant.

So given the fuzziness associated with the definitions of risk, it is no surprise that in CFA Research Foundation’s “A Practical Guide to Risk Management” a very broad definition given by Thomas Coleman is: “Risk management is the art of using lessons from the past in order to mitigate misfortune and exploit future opportunities—in other words, the art of avoiding the stupid mistakes of yesterday while recognizing that nature can always create new ways for things to go wrong.”

2.0 Risk management- Approaches

Some might say: play it safe, don’t take any risk. Unfortunately, there is no such thing as risk-free. The closest to risk-free that one comes to is a sovereign power’s inflation indexed DB pension plan (tell that to the citizens of Greece, though a Government of Canada civil service pension plan might qualify- at least for now). Risk is part of life. Ultimately there are very few things you can control. For example in the context of investments you may be able to control (to some extent): saving rate, spending rate, fees (investment cost), and asset allocation. Almost any path one takes comes with (different) risk(s). Invest all in “risk-free” government bonds you may outlive your assets or may have to have a spend-rate significantly below your lifestyle expectation, or get eroded by inflation over a 30-35 year retirement. Even if you invest in inflation linked government bonds, your personal inflation may be different than the inflation index that the bond is linked with, or as today real returns are negative (especially after tax), or you have to adjust your standard of living to be consistent with what can be delivered with available assets. Alternately if you invest in risky assets then a few years of market losses coupled with required withdrawals to meet retirement expenses, you might end up with a seriously depleted portfolio, unable to recover with the market.

There are three major approaches to pursuing risk control/management: diversification (uncorrelated assets), insurance (life/disability insurance, annuities, buying puts), and hedging (currency hedge, asset-liability matching (ALM), hedging with futures (currencies or market movements).  Having said that definition, measurement, modeling or an understanding of all dimensions of risk can only be described as partial at best, and potentially misleading or wrong at worst, we are still driven to find ways to eliminate or at least mitigate risk to the maximum extent possible.

University of Illinois at its Is Your Financial Security at Risk website has a set of simple questions which might help you to develop a personal risk management plan. One of the important tools associated with this activity is a very simple matrix to categorize risk in two dimensions (‘Probability of Occurrence’ and ‘Financial Severity’).

                                                                             Figure 1

Low or high severity of an unfavorable event would likely have to be judged not in terms of absolute dollars but in context of one’s personal circumstances (i.e. a $10,000 loss to a retiree who has $50,000 assets has different meaning/impact than the same loss to retiree who has $1,000,000 in assets.)

3.0- Dimensions of risk

Let’s consider some of the major dimensions of risk (market (investment), death, disability, longevity, inflation, and, of course especially for Americans, major health/medical expenses) throughout an individual’s life-cycle.

Typically one’s  Total Capital (TC) is comprised of Human Capital (HC) and Financial Capital (FC):


Early in one’s working life Human Capital (HC, the present value of future earnings) is dominant, while at the end of one’s working life (i.e. near or at start of retirement) Financial Capital (FC) is dominant. Let’s look at some of these dimensions and explore how we may deal with them with: diversification, insurance and/or hedging.

3.1- Death, disability and (in U.S.) medical/health expenses are naturals for using insurance to transfer risk

Throughout one’s working life there is a gradual build-up of FC as a percent of TC.  So typically throughout most of one’s working life, when HC represents a significant portion of one’s TC, disability (i.e. inability to earn a living and save for retirement due to serious illness or accident) would be catastrophic to the individual and dependents. So going back to Figure 1 the probability of occurrence of disability is low but the financial severity would be high (even catastrophic if person ends up unable to ever work) so disability fits well in the south-west corner of that matrix; so disability is a risk that one would like to transfer by buying insurance to cover a significant portion of the lost after-tax income generated by work. Similarly, risk of death belongs in the same corner of Figure 1 as a low probability but potentially catastrophic financial impact if one (was not single, but) had a family dependent on one’s income. In this situation again transferring the risk by buying insurance (life insurance) is the natural way to deal with it. One’s death does not have severe/catastrophic financial impact such as when one is single with no financial dependents (e.g. no spouse, no children and parents are fully self sufficient); the reason being that in such a case upon one’s death  one’s expenses go away at the same time as one’s Financial Capital (FC). There are of course other less clear cut situations when one’s death may have severe financial impact such as: maintaining a spouse’s lifestyle (including paying off any existing mortgage) even if the spouse is working, or in retirement when one has a DB pension plan which has no spousal benefit or a spousal benefit of only 50% or 60% of its value or one needed/wanted to support aging parents. Similarly, in the U.S., cost of medical expenses in case of serious illness, even if of only short duration can have severe to catastrophic financial impact on one’s finances, e.g. surgery/hospitalization/drugs can cost tens or even hundreds of thousands of dollars; so south-western box is applicable (perhaps with a ‘large’ deductible).

3.2- Longevity risk (i.e. the risk of running out of money before you die)

Longevity risk represents a key unknown in retirement planning and there are two aspects of this risk: (1) increasing life expectancy for some age-group/cohort (important to insurance companies selling annuities and DB pension plan sponsors), and (2) the large variation in actual years of life remaining for any one individual around this median (i.e. specifically for the 50% of the individuals who exceed life expectancy of cohort). During the 20th century, cohort life expectancy has been increasing; this is a problem for employers funding DB pension plans and insurance companies selling annuities, as it introduces an uncertainty as to their expected total liabilities; of course they will extrapolate known trends and guesstimate future longevity and the impact on their liabilities. But the more critical problem is dealing with a much larger variability of how long each individual will live; specifically, what should be the individual’s retirement “planning age” of death, since half the individuals, by definition of the median, live longer than the “life expectancy”; so the “planning age” question that must be answered is how many years must the retirement assets last? According to the 2006 US government report Life Expectancy in the United States in 2005 Male/Female life expectancy at birth was 74.8/79.6, while at age 65 it was 16.2/19.0 years; the report also projects until 2075 life expectancies at birth to grow 1yr/decade  and about 0.4 years/decade at age 65. (By the way, early in the 20th century life expectancy at birth was increasing at 4-5 years/decade, though the rate of increase has been declining over the past century to the quoted current rate of 1yr/decade.) So some employers are considering the purchase of longevity insurance for their DB plans, however the ‘projected’ longevity increases will no doubt be reflected in the price of the insurance , so barring some revolutionary medical discoveries, they might as well self-insure the expected increases; the revolutionary medical advances, should they occur, might in any case bankrupt the counterparty providing the insurance.  The total pension or annuity cost exposure for a cohort might be of the order of 3-5% per year of increased longevity which is expected to occur over the 20 years following an age 65 retirement; so it is important but tolerable and no doubt that annuities sold by insurance companies already assume very conservative life expectancies. (Unfortunately, many companies’ DB pension plans intentionally use ‘old’ life expectancy data and other aggressive actuarial practices, in order to minimize employer/sponsor’s required plan contributions).

On the other hand, for each individual retiree the exposure is much more significant; at age 65 given that M/F life expectancy is 16.2/19.0 years yet there is a 25% chance that at least one or a 65 year old couple will make it to age 95 or 11 years longer than female life expectancy, we are looking at a 25% chance of retirement costing 50% more than pure based on single M/F life expectancy at age 65. So an individual/couple’s percent cost exposure is an order of magnitude greater than that of a corporation (i.e. 50% vs. 3-5%).  There are many ways used to attempt to manage this individual/couple longevity risk. Of course, it is easy to make sure that you won’t outlive your money; just don’t spend it! But the challenge is to find the “right” balance between spending too much and outliving your resources, and spending too little due to fear of exhausting one’s assets, living significantly below what would be affordable and end up transferring a larger than planned estate to the next generation. (As the old saying goes “if you don’t fly first class, then your children will”.) To secure a lifelong income stream insurance products are commonly urged (though not necessarily used) ranging from annuitization, to guaranteed lifetime income products, to pure longevity insurance products (the latter is the most efficient form of longevity insurance for the individual). Others prefer systematic withdrawal strategies alone or in combination with insurance products. Insurance products, especially annuities, where the time between ‘premium paid’ and ‘last annuity income check’ might even be 30-50 years apart, come with counterparty risk; i.e. that the insurance company might not be around to make good on its promises. (There are various state or industry association guarantee programs which promise to step in should insurance company be unable to pay, but they come with caps.) Generally speaking, few can expect (with the possible exception of public servants with inflation indexed  government DB pensions, with access to printing machines) to set a retirement plan in place at age 65 and forget about it for the next 30 or more years; the key is flexibility to respond to changes around us. Here are some approaches:

-annuitization – whereby one hands over to an insurance company a lump sum premium in order to buy an income stream for life. This might be implemented by complete annuitization, i.e. annuitizing all of one’s retirement assets at start of retirement. Or one might chose to use partial annuitization to secure income necessary for basic needs or only some or all of the assets allocated to fixed income in the portfolio. Annuitization may also be implemented in a staged approach by annuitizing one-third of the sum, targeted for annuitization, at each of ages 65, 70 and 75, thus reducing the interest rate risk (especially in a very low interest environment like today) and improving the mortality credits which increase with age. Individuals have the option to buy inflation indexed annuities to offset the corrosive effect of inflation over a 25-30 year retirement; unfortunately such inflation indexed annuities appear to be only available in the US, not in Canada. By the way when you are wondering how much do you need for retirement, a reasonable starting estimate might be the cost of an indexed annuity to cover your estimated annual retirement expenses, when purchased from a highly rated insurance company. (You can read more on annuities at the Annuity I: What is wealth?, Annuities II: (Almost) Everything you wanted to know about annuities, but were afraid to ask, Annuities III, and Annuities IV  blogs.)

-guaranteed lifetime withdrawal benefit insurance products- often referred to as variable annuities with guarantees or GMWBs or GLWBs or similar names, were designed for those adverse to giving up control over their assets and hand them over to an insurance company in exchange  for a promised lifetime income; instead these variable annuities promise to invest your assets into funds with specified asset allocation (risk) promising an opportunity to preserve and possibly grow one’s assets if funds perform well, but irrespective of fund performance,  they guarantee some minimum lifetime income (typically 4-5% of initially invested amount). So here you have the pitch of downside (income) protection with upside (income and asset) opportunity if performance permits. Unfortunately, for most of these products due to very high annual all-in (fund management and guarantee) costs of the order of 3-4%, the upside is mostly the triumph of hope over reality and the guaranteed income stream is typically lower than the corresponding annuity stream. You can read about GMWB type products in the GMWB I – Guaranteed Minimum Withdrawal Benefit (Preliminary), GMWB II- Guaranteed Minimum Withdrawal Benefit II, GMWB III – Q & A: Are GMWBs more desirable investments in “post-2008” context of low interest rates and ‘RIP’ GMWBs? Who will miss these lose-lose products?  blogs. The one exception which I came across was Vanguard’s  version of this product which I discussed in the Vanguard GLWB vs. other decumulation strategies blog.

-pure longevity insurance- is a form of delayed payout annuity where a single premium at age 65 guarantees a life contingent income stream starting at, say, age 85. Today (spring 2012) each $1 of single premium at 65 buys about $0.65 of annual income starting at 85 (e.g. New York Life), which is an order of magnitude cheaper than an immediate annuity at age 65. Of course age 85 is just past the life expectancy of a 65 year old, but it might allow for planning purposes to assume that your assets need to last only for 20 years. You can read more about this form of insurance in my Longevity Insurance, Longevity Insurance (Delayed Payout Annuities) and Longevity Insurance- What does it buy you? blogs.

Bengen showed in the 90s that based on historical returns, starting with an annual withdrawal of 4% of initial assets invested in a balanced portfolio, can then be increased annually by inflation and portfolio should last 30 years. (Unfortunately the future is unlikely to be just like the past and various prognosticators are warning to expect much lower returns and lower safe withdrawal rates in the future.)

-proportional withdrawal- this is my personal approach to dealing with longevity risk (at this time) whereby one withdraws (depending on one’s age) 3-5% (at age 65, or more if one is >75 or 80) of the current value of one’s balanced portfolio each year to meet current expenses. This approach requires that one be able to tolerate a higher variability in one’s income than some of the other approaches, but at the 4% level simulation suggests that portfolio has very low probability to exhaust in 30 years. The Vanguard GLWB vs. other decumulation strategies blog discusses this proportional withdrawal strategy, as well one which includes a floor and ceiling on annual changes in withdrawal rate which somewhat reduces the extent of income variability but still minimizes the risk of exhausting one’s assets. For a 65 year old couple, unless they are known to have health issues suggesting lower than average life expectancy, death at age 95 (for the younger of a couple, e.g. if wife is younger) would be a reasonable starting point for planning purposes. (As one ages, and the number of remaining years in retirement decreases, the withdrawal rate may be increased without increasing the risk of running out of money. Of course as one ages one year, this reduces the remaining years in retirement by less than one year, since life expectancy (age at death) increases with age; recall in 2005 M/F life expectancies at birth and age 65 are 74.8/79.6 and 81.2/84, respectively.)

-Jonathan Clements some years ago, when he was personal finance columnist at the WSJ, suggested a simple approach for individuals who have limited retirement resources other than pension income. Take 85% of your retirement assets at 65 and withdraw 1/20th in year 1, 1/19th in year 2, 1/18th in year 3 until age 85. Take the other 15% and invest it in stocks and TIPS; if still alive at 85 take the 15% put aside and buy an annuity. (Using (late e.g. age 80-85) annuitization also might make sense for somebody using the proportional withdrawal approach early in retirement, should they later find that their assets have dropped to the threshold required to buy an annuity to cover expenses.)

– Financial Engines was quoted to operate a similar approach whereby one’s 401(k) is allocated 80% bonds and 20% stocks. Then 85% of the total, 65% bonds and 20% stocks, are decumulated between 65-84, and the rest can be converted to an annuity if alive at 85.

-another potential approach (if implemented as part of much needed pension reform) is a spin on the CPP (or Social Security for those who have the confidence that commitments will be honoured over the next 30-40 years) of adding a pure longevity insurance payout option funded by forgoing a small percentage of one’s annual entitlement. For example, forgoing (inflation indexed) $1,000/yr, $2,000/yr or $3,000/yr between age 65 and 85, would result in an unindexed incremental (to existing entitlements) income stream starting at age 85 of $16,000/yr, $32,000/yr or $48,000/yr, respectively (see my Pure longevity insurance payout option in CPP would reduce retirees’ longevity risk blog).

3.3- Inflation risk

An annual inflation of 3% is enough to wipe out 60% of your buying power over 30 years. Therefore, an immediate fixed annuity which meets your immediate needs at age 65, will only deliver only 40% of its age 65 buying power if you or your spouse should live to age 95 in the 3% inflation scenario. Historically T-bills would return ‘inflation +1%’, intermediate to long-term Treasuries returned about ‘inflation +2%’; in the current artificially low interest rate environment of “financial repression”, 10 year Treasuries actually return less than expected inflation, i.e. negative real returns. The equity risk premium, ERP, (depending on whose definition you use) returned over 5% in excess of intermediate to long-term Treasuries, however (again depending on whose prognostication you might want to believe) we should be expecting lower ERP in the future, say 4% (some are forecasting ERP as low as 2%). So for a 50:50 stock/bond portfolio (tax aside) we might expect a return of ½*(‘inflation+2%’ + (‘inflation +2%’)+4%)) (i.e. real return of 4%). i.e. this approach would suggest that unless we have very serious market downdraft during the early years of retirement, we would stand a reasonable chance not only not to exhaust but on the average the portfolio would maintain its real value even with a 4% proportional draw over 30 years of retirement. On the other hand, investing in risk-free assets, only earning negative real returns, and hoping to draw about 4% of the assets at the start of retirement, with any semblance of keeping up the buying power of the annual draw with inflation would guarantee failure.

Some mechanisms to deal with inflation include:

-diversified portfolio including higher return risky assets with risk a tolerance compatible asset allocation; by not settling for the (historically) risk-free government bonds, investors historically have earned a ‘risk premium” (e.g. as in equity risk premium). So assuming on the order of real 2% in intermediate bonds and a further real 4% as equity risk premium (though current expert forecasts indicate lower future returns), then by adding some proportion of risky assets to one’s portfolio, the expectation is that over time the higher equity returns could help compensate for the corrosive effects of inflation

-TIPS(US)/RRB(Canada)s are typically government issued bonds which compensate investor for inflationary losses by increases in face value of bond as well as its the annual payout. Unfortunately, one is still exposed to interest rate risk and these are best placed in tax-sheltered accounts since increases in capital (bond face value) due to inflation are taxable each year even though there is no corresponding cash received until bond is sold/matures.

-commodities, real estate and gold in the portfolio are typically considered not just diversifiers but also inflation hedges

-inflation indexed annuities and longevity insurance (both only available in the U.S.) are mechanisms increase income to compensate for inflation. To be effective the inflation indexed annuities would typically require giving up control of a significant portion of one’s assets. Pure longevity insurance, if bought at age 65, would typically only start producing income after about 20 years, but would require giving up control over a much smaller portion of one’s capital. 

3.4- Market (or investment) risk

As one moves through one’s life-cycle, ideally the importance of FC (Financial Capital) grows and it becomes an increasing and ultimately dominant percentage of one’s TC (Total Capital). (Of course someone who saves nothing during his working years will have only the government and/or employer pension as FC).  Also, as one approaches retirement, available Financial Capital will more than likely be the dominant source/determinant of retirement income. The problem is that returns are directly related to risk (though not all risk is necessarily rewarded). In today’s low interest environment, most people will not have accumulated sufficient FC by retirement to be able to finance potentially a 30-40 year retirement, if they exclusively invest in risk-free assets. So typically they must expose themselves to some extent of market risk.

Let’s now look how market risk control might be pursued using diversification, insurance and hedging.

3.4.1- Diversification

Diversification was always considered one of the primary mechanisms for market risk control. The simplest form of diversification is to combine ‘risk-free’ cash and government bonds with risky assets; simply using the ‘risk-free’ fixed income part of the portfolio as both a stabilizer and/ provider of ‘short-to-medium term’ liquidity to meet expenses. More commonly when people speak of diversification, they mean combining different asset classes (e.g. stocks, bonds, commodities, real estate) which historically had low correlation with each other, to achieve a portfolio delivering a higher return with lower volatility than any of the individual components then the components. Similarly diversification can be applied within asset classes: among countries/regions, sectors (financial, materials, pharmaceutical, industrial, etc), company size (small, medium, large), style (value, growth).  Ideally one would like to combine assets which are correlated in good times and uncorrelated in bad times (not an easy task). Unfortunately, when things go seriously wrong as they did in the 2008 crash there is a tendency for investors to run from all risky assets to perceived safe havens like Treasurys. Commenting on how to model this crisis behaviour, in the September 2011 CFA Institute’s conference proceedings “Advances in risk management and risk governance” Leslie Stahl writes that “When problems occur, what happens first mathematically is that correlations go to 1 or –1. Yet, how many investment managers actually stress test correlations going to 1 or –1? …Different types of stress tests can be used. One approach is to use individual facts and assumptions, such as interest rates rising or falling, credit spreads narrowing or widening, correlations changing, or equity prices going up or down. Another approach is to use historical stress scenarios, such as the financial crises in 1987 or 1994, the Asian flu crisis, or the dot-com crisis. Another approach is what I call “management nightmares.””

Examples of diversification-based approaches to risk management are target—risk and target-date funds. Target risk funds typically maintain a constant (or within a narrow band around a target asset allocation and they are available at three risk levels: low, balanced and high. (e.g. MB LifePlan Target Risk Funds and Vanguard LifeStrategy Funds). Target Date funds on the other hand have an age-dependent glide-path of risk (or more correctly of asset allocation) with a gradual reduction of risk (or rather equity allocation) reflecting the supposed reduced risk tolerance with age. (Some advise taking only as much risk as necessary for a shorter remaining retirement with increasing age, rather than based on one’s risk tolerance). A common problem with both target risk and target date funds is that these funds have a combination of equity and fixed income assets this causes both: (1) overall asset allocation problems (since most investors are not 100% invested in these funds, it is difficult to maintain the investors’ overall strategic asset allocation), and (2) asset location problems (i.e. it is not possible to cleanly place equities in taxable and fixed-income in tax-deferred/after-tax accounts) for most investors. Other approaches don’t just assume that static asset allocation results in static risk level (as suggested in Target Risk Funds) or even just reduce risk with age (e.g. reduced equity asset allocation in Target Date Funds), but argue (realistically) that a specific asset allocation does not necessarily correspond to the same risk level over time, so they look at dynamic asset allocations such as Risk Controlled Investing.

In the Financial Times’ “ETFs should be used to their full potential” Felix Goltz writes that Risk Controlled Investing (RCI) are “…strategies (which) dynamically adjust allocations between low-risk government bond ETFs as a core portfolio and riskier equity ETFs as a satellite portfolio. Rather than considering risk only at a fixed horizon, RCI takes into account investors’ aversion to intra-horizon risk. After all, investors are averse not just to end-of-horizon risk but also to negative outcomes within the investment period. The idea is to manage risk by respecting a risk budget relative to a floor level of wealth. While the focus of RCI is on limiting draw-downs when the risk budget is low, it also allows more risk to be taken on when the risk budget is high, thus providing a source for performance generation. In particular, the pre-commitment to risk management allows one to take on higher exposure to equity ETFs at the initial stage compared to a static allocation strategy. A main advantage of the dynamic risk control approach is that no forecasts are required to make allocation decisions. The risk budget alone determines how much weight is given to stocks versus bonds. (It is not clear what form implementation actually takes, though it does sound similar to the Constant Proportion Portfolio Implementation (CPPI) approach to risk control discussed further down in this section.)

While diversification still works, it is less effective than in the past for: obvious reasons like increasing globalization driving economies of all/most countries/regions to move together, and less obvious reasons like increased/increasing use of indexation. Sullivan and Xiong in CFA Institute Financial Analysts Journal’s “How index trading increases market vulnerability”  argue that “the growth in trading of passively managed equity indices corresponds to a rise in systematic market risk…U.S. equity portfolios have become less diversified in recent years; returns for all subsets have become more correlated, leaving no areas for investors to improve diversification and thus mitigate risk…We suggest that the observed rise in systematic risk emanates, in part, from growth in passive index trading, especially ETFs, owing to increased trading commonality over time and across stocks”; the other factor is institutions’ and individuals’ synchronized risk-on/risk-off behaviour. Thus the correlation among assets has been increasing in the past decade resulting in lower benefits of diversification. And as indicated above, when serious system-wide problems occur all bets are off and “tail-risk” event can materialize and thus the pursuit of tail-risk protection is undertaken.

In the Financial Times’ “University endowments give a lesson in risk” John Authers discusses that the simple principle of “don’t put all your eggs in one basket” is not so easy to implement. The traditional approach of allocating 60% to stocks, 30% to bonds and 10% to cash, was extended by Yale’s David Swensen to add “other asset classes”, like significant doses of commodities, hedge funds and private equity, and Yale achieved 11.8% returns over the last decade while the rest of the market was down. However when the market tanked in 2008/9 the Yale portfolio dropped almost 25%! The author further observes that Yale had first mover advantage in private equities and thus got the best managers and the best deals. The second lesson is that what we want is not different asset classes but different risk factors. The third point is that Yale loaded up with a lot of illiquid assets and didn’t have enough liquidity to meet the operating needs of the university.

Constant Proportion Portfolio Insurance (CPPI) is a risk management approach whereby asset allocation is dynamically controlled to reduce risk as you approach an asset ‘floor’ below which you must not fall, and increase risk as your assets increase from the set ‘floor’. That ‘floor’ is set in the investor’s personal context and may for example be set to the cost of an inflation indexed or un-indexed annuity to meet one’s musts or basic needs. In Perold and Sharpe’s “Dynamic strategies for asset allocation” they provide a simple explanation of the workings of CPPI, where dollars allocated to stocks in one’s portfolio is calculated as

$Stocks= m * ($Assets-$Floor) where m>1

with investor choosing the value for ‘m’ (m>1) and the ‘$Floor’. “This floor grows at the rate of return on (T-)bills, and must initially be less than total assets. If we think of the difference between assets and the floor as a “cushion”, then the CPPI decision rule is simply to keep the exposure to equities a constant multiple of the cushion…Under a CPPI strategy, the portfolio will do at least as well as the floor, even in severe bear market. Such a strategy puts more and more into (T-)bills as stocks decline, reducing the exposure to stocks to zero as the assets approach the floor. The only scenario in which the portfolio might do worse than the floor is if the market drops precipitously before one has had the chance to rebalance. With a multiplier of two, the market can fall by as much as 50 per cent with no rebalancing before the floor is endangered.”

Most of the risk management papers do not distinguish between risk during the accumulation of investors’ life-cycle from the risk during decumulation, and they are mostly focused on the former. Now that the leading edge of the boomers has entered decumulation phase, there is the growing realization of the increased level of risk in this life-stage, which is the result of the interplay between market returns, portfolio costs, withdrawal rate, maintenance of real spending power and minimizing the chance of running out of money before an uncertain date of death.

You might ask whether a mix of stocks and bonds in one’s portfolio should be done for purposes of diversification and be driven by the correlation levels of stocks and bonds, or in order to protect assets necessary for “musts or basic needs” in retirement which would suggest cash-only or LDI/ALM-based allocation (discussed later on in this blog) to risk-free assets to cover 5-10 years of basic expenses. According to Charles Ellis, in his classic “Winning the Loser’s Game- Timeless Strategies for Successful Investing”, any assets not required to cover the initial 10 years of expenses , might be considered suitable to be invested 100% in equities (or other risky assets).

Or, as in’s “Portfolio management needs to mature” Mark Yamada writes that correlations might drive diversification strategy, but the investor’s needs/wants should be explicitly factored into the equation. He suggests a hierarchy of goals approach: (1) basic (food clothing, shelter), (2) lifestyle enhancements (cottage/condo, travel…), (3) legacy (grandchildren’s education, philanthropy…) If respective proportions allocated to me these goals are 60%, 25% and 15% in this case, and given that we can afford very little risk on (1), more on (2) and even more on (3), then stock/bond allocations for these three goals might look like: (1) 20/80, (2) 60/40 and (3) 80/20, for an overall allocation of 39/61 for this investor.

3.4.2- Hedging market exposure based on/and with VIX

As indicated in the previous section discussing diversification-based risk-control, the reality is the target-risk and target-date funds actually don’t control risk directly, but they control asset allocation as an approximate proxy for risk; the implied assumption is often that equity risk (volatility) is (at least in the near-term) constant and it determines the appropriate asset allocation. More recently, one finds growing enthusiasm for factoring in the changing nature of volatility as reflected by the VIX and use it as an implementation trigger for various hedging approaches to one’s portfolio. For example in “How to manage tail risk” , with more details in “A constant volatility framework for managing tail risk”,  a constant portfolio volatility approach is suggested given that volatility of portfolio components (e.g. equity) varies with time; thus one could define periods of high and low volatility, and reduce exposure of portfolio during periods of high volatility using a short-term market volatility driven long/short futures overlay (rather than options). (Sounds good but difficult to determine to what degree there is some element of what some might consider data mining involved; this also says that market timing works (or could have worked, at least in retrospect), which as we know  is very difficult to do. The article does not provide the data used on cost of long/short futures as volatility changes.)  Another volatility triggered approach is suggested by Mark Yamada in Benefits Canada’s “Pension investing using ETFs” where he describes a volatility driven hypothetical portfolio where asset allocation is determined by the value of the S&P 500 implied volatility index (VIX).  If VIX<20 then 100% stocks, if 20< VIX < 30 50:50 stock/bonds, and if VIX>30 then 100% bonds.  “We believe wider asset allocation shifts than those many investors have become accustomed to, are the future of investing in volatile markets.” Target date funds are flawed with their predefined (volatility independent) glide-paths. He argues that reducing risk simply according to the age of the individual, is insufficient, and environment (volatility) must be factored in to maintain “consistent risk”. “This approach is theoretically better than anything available today for DC plan investors.” (An interesting idea.)

Phil Davis in the Financial Times’ “Hedge funds play with market turbulence” suggests that volatility instruments (e.g. VIX) may be productive in portfolio risk management by buying volatility to hedge market exposure. But the hedging comes at a price and their overuse (too much and/or for too long) can be a significant drag on performance. According to in the Financial Times’ “Investors seek protection from extremes” investors are piling into hedge funds which promise tail-risk protection, but unfortunately the traditional things used for hedges (e.g. VIX) have become much more expensive. “The challenge for hedge funds will be to find cheaper sources of tail-event hedges such as structured products, conditional hedges and use of longer term derivatives.” However investors are advised not to take “unusual risks in their attempt to hedge”

VIX strategies were inspired by the observation that during the 2008 market crash, VIX increased as the market was decreasing, however these strategies have not fared well since 2008. In the WSJ’s “Beware those ‘VIX’ plays” Ben Levisohn takes readers through the workings of VIX based hedges, in which he argues that “long term investors likely would have lost money…in most VIX-linked products…because these products at best can provide only imperfect exposure to the returns of the VIX”. The theoretical VIX tracks the implied volatility (which is priced into options), whereas products can only “track the VIX indirectly through futures contracts”. The difference can be significant in part due to the typical process of “sell shorter-term futures contracts and buy longer-term ones. In calm markets, like today’s, the later months are more expensive than the earlier ones. That process often eats into returns.” Some argue that these are tactical tool. “If you think something is going to happen soon, you buy, and if nothing happens, you sell.” (Good luck with that!) For a deeper dive you can read IndexUniverse’s “Portfolio applications for VIX-based instruments” in which Cherney, Lloyd and Kawaller conclude with “Developing cost-effective strategies to hedge sell-offs in the equity markets is challenging. The negative correlation of the VIX to the S&P 500, the performance characteristics of the VIX futures indexes, and the convexity of daily resetting instruments enable sophisticated managers to design strategies to hedge significant equity market sell-offs and more efficiently execute their views on volatility.” (Good luck with that too!)

In Barron’s “No easy- or cheap- remedy for volatility” Beverly Goodman writes that “Volatility is certainly something investors need to be aware of. But first, you need to understand exactly what it is, and then you can decide what, if anything, you want to do about it—minimize it, capitalize on it, or ignore it altogether.” She explains why risk and volatility are not the same and in fact point out that at times higher volatility funds are less risky than lower ones (e.g. “look at the fund’s upside/downside capture ratio… An upside/downside capture ratio measures how much a fund has outperformed (gained more than or lost less than) a benchmark.” So when Upside capture ratio is much higher than downside that suggests less risky than the market even if volatility suggests otherwise.)

So VIX/volatility based hedging approaches ended up to be far from the panacea they were advertised to be, only a short couple of years ago.

3.4.3- ALM (Asset Liability Management) or LDI (Liability Driven Investing)

Another type of hedging, which used to be the gold standard for DB pensions, before employers decided to throw caution to the wind and typically use a 60/40 stock/bond portfolio, is ALM or LDI approach which is focused at matching the bond-like DB pension plan liabilities with bonds which match duration of the plan liabilities. The same principle can be applied to individual retirement portfolios as described by Zvi Bodie in the 2011 CFA conference presentation “The long-run risk of stock market investing: Is equity investing hazardous to your client’s wealth?” . After putting again a stake through the heart of time diversification (the flawed theory that stocks are risk-free in the long-run, e.g. see my Time Diversification: Stocks are less risky over the long-term??? (Not!) blog), he continues to advocate for a very defensive approach to retirement planning and portfolio construction. He suggests an LDI approach based on the real return available from long-term TIPS (2%). He then suggests either 100% TIPS portfolio to match liability stream with equity participation notes (EPNs); each “EPN is a combination of a zero-coupon bond and an equity option or, an equity portfolio plus a put on the portfolio. The maximum loss can be limited, whereas the unlimited upside potential is retained.”

Also in Edhec-Risk’s  “Diversification is not sufficient for managing risk” Felix Goltz writes that diversification is not enough but hedging and insurance are needed as well… “While diversification is used to construct portfolios achieving the highest risk-adjusted returns, hedging is done to shed risk that cannot be diversified away. In fact, the theory of optimal asset/liability management (ALM) indicates that efficient capital allocation involves two portfolios—a performance-seeking portfolio (PSP) constructed through diversification and a liability-hedging portfolio (LHP) used to deal with the variability of the stream of liabilities arising from different sources, mainly interest rates and inflation2” “Dynamic asset allocation theory suggests that downside risk constraints, or asset value floors, can be implemented through an optimal state-dependent weighting of the PSP component depending on the size of the risk budget.

In this way, risk exposure can be adjusted in an optimal manner, allowing at the same time the highest possible exposure to the upside potential of the PSP component within the imposed risk constraints” “Broadly speaking, investment management concerns optimal expenditure of risk budgets. To this end, diversification, hedging, and insurance represent three complementary rather than competing techniques.”

3.4.4- Insurance for Market Risk

In “Investment management after the financial crisis” Fabozzi et al write that “Controlling the risk of pure losses is typical of insurance. Insurance works by collecting a payment, called a “premium” that will cover future claims. If potential losses are small, numerous, and uncorrelated, as in the case of auto insurance, then the insurer is basically covering a fixed cost. But if the distribution of potential losses is fat tailed, as in the case of earthquakes, the insurer faces the risk of insolvency unless the premiums are adequate and its capital cushion sufficient (see Embrechts, Klüppelberg, and Mikosch 1997)… The collapse of Lehman Brothers in September 2008 illustrated just how important counterparty risk is to investors using risk control strategies. The head of a corporate pension fund in the financial services sector remarked, “There is such a thing as counterparty risk. In the past, we used to look at ratings and ask for collateral (proportional to how bad the rating is). We have all learned that collateral and margin calls are very serious business.”… “There is now a greater understanding on the part of institutional investors that asset allocation is the issue rather than stock picking.”

The most obvious form of insurance in a market risk context is buying of puts, which give the investor the right to sell assets for a finite period of time at a predetermined price; essentially putting a floor under the asset value. Puts are a great idea, but the cost significantly erodes returns.

In the market risk context during decumulation, some might consider variable annuities with GMWBs as part of the insurance leg of approaches to risk management. We discussed GMWBs in the Longevity Risk management section. These products are typically composed two main elements: an expensive mutual fund and an insurance company guarantee of some minimum lifetime income, rather than a guarantee that assets won’t drop below some level. With the exception of Vanguard’s product (discussed in Vanguard GLWB vs. other decumulation strategies), the high fees usually associated with these products typically insure that once decumulation starts there is relatively little upside on income or assets and those exceeding life expectancy might have been better off with an annuity, from an income and asset perspective.

3.4.5- Hedge or insurance costs rarely justified (in market risk context)

However Litterman and Montier, in separate articles argue that the hedge or insurance costs are rarely justified.

In the Financial Analysts Journal’s “Who should hedge tail risk?”  in which Robert Litterman argues that investment banks are the natural buyers of tail-risk insurance and long-term investors are the natural sellers of such insurance (exactly the opposite of what actually happens). Litterman looks at three options for long-term investors who are worrying about their tail-risk: (1) “buy equity tail-risk insurance”, (2) “sell some equity”, and (3) ‘sell even more equity exposure and also sell equity tail-risk insurance”. He shows that of these the first one is the most expensive and the third one the most effective as measured by volatility reduction and return enhancement between 2005-2011. He says that “My advice to long-term investors is that the next time someone knocks on the door selling a tail-risk insurance product, they should ask for a two-sided market. Perhaps the opportunity is on the other side.”

Similarly, GMO Capital’s James Montier in “A value investor’s perspective on tail risk protection: An ode to the joy of cash” concludes that “Tail risk protection appears to be one of many investment fads du jour. All too often those seeking tail risk protection appear to be motivated by the fear of missing out (not fear at all, but greed). However, the surge of tail risk products may well not be the hoped-for panacea. Indeed, they may even contain the seeds of their own destruction (something we often encounter in finance – witness portfolio insurance, etc). If the price of tail risk insurance is driven up too high, it simply won’t benefit its purchasers.”  And In Barron’s “Tail-risk tribulations” Michael Santoli writes that “There has been a vogue for financial instruments that purport to insulate the wary investor from “tail risks” events. But such protection can be tricky to pull off correctly.” Quoting GMO’s James “Montier makes the point that defining the precise risk, then designing its antidote, and then weighing exactly when one should begin shouldering the cost of carrying such insurance, is easier said — and sold — than done. One must, he says, be a value investor when considering all these factors, and in the end plain old cash is probably an under-appreciated cushion against bolts from the blue. “Over-engineering” is an important hazard, he notes, as “it is too easy to construct an option that pays out under a very specific set of circumstances,” yet that does not by definition offer broad tail-risk protection.”

Same topic is addressed in the NYT article “A new investment strategy: Preparing for end-of-times” also discusses new funds aimed at managing tail-risk but some argue that : “I kind of believe that the best way to reduce risk is to take things out of the portfolio, not add them,” said Ken Grant, president and founder of Risk Resources.”

The likely reason that market risk is not a natural for insurance islikely because it does not meet the potential losses do not meet the “small, numerous and uncorrelated” criteria necessary to make the losses ‘fixed’ and easy to be covered by the ‘premium’ charged.

4.0- Other risk management approaches

The Economist’s “Not up in the air” about risk management lessons for companies, might remind some of individual financial risk scenarios one might reflect upon, like: a(nother) 50% drop in equity prices, banks stay closed for one or two weeks (no ATMs, no credit card transactions), currency controls are introduced in the U.S. so you can’t get your US$ out (including those resulting from security sales), your underfunded DB pension plan sponsor becomes bankrupt, …..but the article’s message is “less about trying to predict what unlikely event may come along, and more about creating mechanisms and relationships that would help the firm (individual) and its partners (family/friends/business relationships) respond with agility if disaster did strike.” What is recommended is regular brainstorming (e.g. a ‘pre-mortem’ described below), by the firm’s disaster strategy team with its network of partners (suppliers and customers) about potential threats and how to respond. A related opinion piece in the WSJ “Man and the Volcano” comes to similar conclusion “we can’t stop it from erupting, but we can adapt to the danger” or that “mother nature can neither be appeased nor truly conquered, and that it behooves us to approach her with imagination—and humility”.

5.0- Bottom Line

What can you actually control? Well actually there is not much you can control. The knobs that you can actually adjust are:

-how much you save (inflow to your retirement portfolio/assets)

-how much you spend (outflow from your portfolio to meet your needs)

-costs associated with your investments (another type of outflow, the year after year drag on market returns or corrosion of your assets…these are fees, loads, transaction costs, etc )

-asset allocation (which to a large extent is just a reflection of your risk tolerance and which determines what part and what extent do you participate in the financial markets); the diversification built into your asset allocation is one of the best tools for (market) risk management.

Jamie Dimon, when he announced the $2B losses last week, said that JPMorgan staff violated the Dimon principle, though according to Jason Zweig in the WSJ’s “Polishing the Dimon Principle”, Dimon did not explain what that principle is. Zweig instead refers in his article to the Feynman Principle, which the physicist gives as “You must not fool yourself—and you are the easiest person to fool”, which I translate as the biggest risk is when you believe your own B.S. Zweig also warns that  “You also can fool yourself by placing too much faith in the findings of supposed experts.” And in conclusion he suggests a ‘pre-mortem’ whereby you “Gather a group of people whose views you respect. Ask them all to imagine looking back, a year from now, at the investment you just made—and that it has turned out to be a disaster. Have them list all the possible causes of the failure. That may well help you see how it might have been avoided. Above all, remember that the smarter you are, the more easily you can fool yourself.”

The cost of hedging and insurance is rarely justified in a market risk management context. Use insurance where it makes sense (e.g. life, disability and health/medical). We must build our diversified portfolios with humility and full understanding of our risk tolerance. So much for risk management!

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