Risk - Measure It and Manage It


Risk – Measure It and Manage It

Many people talk about risk, but don’t know how to measure it.  How do you measure risk?  At THOR, while we consider many risk metrics, there are three key risk components on our radar.  First and foremost is the risk of permanent loss of capital.  The second important risk consideration is the price paid for an investment.  The third risk we consider is the price volatility of the portfolio.  One way of measuring price volatility is to look at the beta of a portfolio.  Beta measures how correlated a portfolio’s price movements are compared to the market.  The market’s beta is 1.00.  If a portfolio is riskier than the market, as measured by price movement, the beta will be greater than one.  If the portfolio is less risky than the market, the beta will be less than one.

With those risk considerations in mind, let’s take a look at two hypothetical portfolios.  One portfolio experiences 40% more price volatility than the market while the second portfolio experiences 40% less price volatility than the market.  The portfolio with more risk has a beta of 1.40 while the less risky portfolio has a beta of .60.  Here is an example of the returns each portfolio could produce over a 5 year period:

beta example

In good markets like year 3, the higher beta portfolio performs very well.  In poor performing markets like year 4, the higher beta portfolio performs significantly worse than the market.  An investor needs to ask: “Is the higher return of approximately 0.4% annualized in the higher beta portfolio worth the increased dispersion of returns experienced with 40% more volatility than the market?”  With US large-cap stock valuations at historical highs, this is a time when a prudent investor should be looking to lower beta in their portfolio, not increasing it.

What does this mean for your portfolio?

As an active manager of our clients’ portfolios, we will increase or decrease risk based on fundamentals and our proprietary investment models.  There are times when we add more risk in our clients’ portfolios such as at the end 2008 and times when we have reduced risk like the tail end of 1999 and the present time.  We are reducing the beta of our portfolios today in 3 ways: 1) We have a lower exposure to equities than our target objective; 2) We have an overweight position to assets that are non-correlated, which means their price movements are not dictated by what happens in the stock market; and 3) In our equity investments, we are invested in areas that have a higher economic margin of safety.  These are investments we believe have more upside potential in comparison to downside risk.  History tells us that these attributes tend to hold up better in down periods.  Actively managing the risk of a portfolio is imperative today as investors have become complacent and forgotten that market corrections are the norm, not the exception.

Recent News

Will Italy Be Saved by the ECB?

The Italian election at the end of May has shaken up Europe and the Italian bond market.    The change in Italy will make things more volatile over the next several months.    We believe that the ECB will keep Italy afloat with purchases of Italian Government bonds.       When Mario Draghi steps…

Read More

What is a Backdoor Roth IRA?

Roth IRAs are a powerful way to save for retirement.  The beauty of a Roth IRA is that all growth and withdrawals from the account are tax-free and having a tax-free income source in retirement can be extremely beneficial.  It is important to keep in mind that any contributions to…

Read More

Ballooning Corporate Debt

Corporations have increased debt loads over the past few years because of the Federal Reserve’s ultra easy monetary policy. Now with rates going up, stress is starting to show up in the corporate bond market. With over $4.4 trillion in corporate bonds coming due by the end of 2022, higher…

Read More