The standard approach to managing risk with mutual funds often revolves around diversification within and across asset classes. However, this approach may not be effective, particularly during significant market pullbacks. The diversification of stock holdings, for example, does not protect investors when the overall market experiences a significant decline, such as a 50% loss in value.
While it is true that diversifying stock holdings can mitigate risk compared to investing in a narrow basket of stocks, the overall exposure to bear markets remains. Mutual fund advisors often recommend allocating a certain percentage of the portfolio to income-based assets like bonds to address this concern. Holding a balanced portfolio of 50% stocks and 50% bonds, for instance, can reduce the decline during a stock market downturn since bonds tend to be more stable. During the Great Recession, investors with well-diversified bond holdings saw a smaller decline compared to those heavily exposed to the stock market.
Proponents of mutual funds may argue that market recoveries have historically followed downturns, minimizing the long-term impact of declines. However, risk is defined as the potential for a holding to go down, irrespective of its eventual recovery.
This argument often assumes that there are only two alternatives: holding or selling. It overlooks the strategy of selling during troubled times and re-entering the market during the recovery, although proponents may not offer a strong rebuttal against this approach.
Many investors did sell their holdings during significant declines, but not all re-entered the market once it rebounded. Regardless, these declines represent inherent risks, and taking a long-term view, while ignoring short-term risks, may not always be the most appropriate strategy. It is important to question whether alternative approaches may offer better risk management and return potential for investors.
Why Risk Management Matters
The industry’s typical approach of selling the “buy and hold” strategy with passive risk management components does offer some risk management, but it tends to be inflexible and may leave investors overly exposed to risk.
In practice, many investors find themselves too exposed to risk, especially during bear markets. This is not limited to those who sold their positions at the wrong time but includes anyone who becomes upset with their investments during market downturns. When mutual funds are sold to investors, risk assessments are conducted to determine their risk tolerance. However, often, individuals who are comfortable with a 20% drawdown are considered suitable for a large exposure to the stock market, despite the fact that stock markets can experience declines greater than 20%.
If we were to use the actual historical performance of stocks, such as a benchmark of 50%, we would allocate a higher proportion of portfolios to other assets. For example, if someone is comfortable with a 20% drawdown, this would mean allocating no more than 40% of their portfolio to stocks. For those with lower comfort levels, this allocation would be adjusted downward accordingly.
While managing risk involves more than just ensuring investors can handle drawdowns, achieving this level of comfort would help prevent panic reactions when positions go against them significantly.
We also need to challenge the notion that a fixed asset allocation is the only way to manage risk. Risk can be managed dynamically, similar to how traders approach the market. Traders take on a certain amount of risk in their trades, which is often less than what many long-term investors accept by holding through any market downturns.
A more dynamic approach to risk management involves setting specific risk thresholds. For example, if an investor is not comfortable with more than a 10% drawdown, they can exit their position when it reaches that level and re-enter when circumstances warrant. This approach allows individuals to tailor their risk exposure based on their personal risk tolerance.
By adopting a dynamic risk management strategy, investors can set their desired risk levels and avoid exceeding their tolerance for risk, as long as they stick to their plan and adjust their positions accordingly.
Risk is Not So Subjective Though
It is essential to differentiate between subjective and objective risk management when considering investment decisions. While subjective risk tolerance is crucial in avoiding psychological distress and poor decision-making, objective risk management involves setting limits based on an objective assessment of potential losses.
In traditional buy and hold strategies, the maximum objective risk is often seen as unlimited, as the goal is to hold investments for the long term. However, to align with subjective risk tolerance, subjective standards like the commonly cited 20% drawdown are applied to adjust risk exposure.
To achieve proper objective risk management, it is important to have controls that account for the unlimited potential risk inherent in investments. This means establishing objective limits that go beyond subjective comfort levels, even to the extent of losing the entire investment if one is willing to accept that level of risk.
Objective risk management involves assessing the probabilities of adverse movements and making decisions based on objective criteria. For example, when crossing the street, we evaluate both directions to determine if it is safe to proceed.
Managing a mutual fund portfolio effectively requires a similar approach of monitoring the flow of the market and making decisions based on objective criteria. This involves assessing the probabilities of market movements and adjusting positions accordingly.
By incorporating both subjective risk tolerance and objective risk management controls, investors can strike a balance that allows them to navigate the investment landscape with a clear understanding of potential risks and rewards.
How We May Manage Mutual Fund Risk Actively
Regular assessment of investments is indeed crucial for effective management of both performance and risk. While investments generally involve longer time frames compared to short-term trading, monitoring is still necessary.
Traders tend to act upon short-term trends, as their trades are often of short duration. Looking at longer time frames may not be practical for trades that only last a few minutes or even seconds.
For investors who aim to average their holdings over several years, it is still possible and important to evaluate performance over these longer time frames. Managing longer-term time frames can be easier than managing shorter ones because there are fewer trends to track and analyze.
Investors can set up charts with weekly or monthly bars to assess performance. Monthly bars, in particular, can filter out insignificant market moves and present longer-term trends more clearly. This approach can be helpful, especially for less experienced investors, as it allows them to discern longer-term trends and make informed decisions.
By regularly evaluating investments using appropriate time frames and charts, investors can effectively manage performance and risk while aligning with their long-term goals and investment strategies.
Learning To Manage Risk
Simplifying the analysis of performance on charts can be beneficial, especially for amateur investors who do not invest for a living. Risk management involves identifying when the longer-term trend is moving against us, which can be relatively straightforward to observe.
The goal of risk management is not to perfectly time market tops and bottoms, as such precise predictions are unrealistic. Instead, the objective is to exit investments when a downturn is underway and sufficient momentum has been established.
By examining a monthly chart of the S&P 500 over the past 40 years, we can observe distinct trends. The market experienced a significant rise from the early 1980s until 2000, interrupted by minor pullbacks. The period from 1995 to 2000, known as the tech boom, was characterized by a continuous ascent that eventually led to a bubble, followed by a 50% decline in market value.
Three years later, the market stabilized and underwent a 33% increase until the housing bubble occurred. Recognizing the shift in momentum during these downturns was not particularly difficult. The subsequent decline resulted in a 60% pullback.
Since hitting the bottom in 2009, the market has been on an upward trajectory, with the index tripling in value. However, it is important to be cautious and mindful of potential future bear markets, as no trend can last indefinitely. The current bull market may continue for several more years or experience a significant correction.
Depending on one’s desired investment time frame, shorter time frames like weekly charts can be used, but the underlying principles remain the same across all time frames, from monthly charts to shorter-term charts.
The aim of investing is to have funds allocated to other investments during periods of significant market decline and heightened risk. This approach can effectively limit the impact of downturns, minimize losses, and improve overall performance and rate of return on mutual fund investments.
