The retail equity investor’s guide to risk management
Head of Equity Strategy
Summary: Concentrated equity portfolios are common for many retail investors leading to very high risk. We show that by blending a 5-stock portfolio 50/50 with an ETF that tracks the broader equity market the risk is brought down considerably without sacrificing the long-term expected return. If an investor is willing to lower return expectations a bit then the ETF tracking the equity market can be switched to track an asset allocation and reduce risk even more. Finally, we highlight the risk to real wealth from inflation and what can potentially offset some of that risk.
What is risk?
Last year I wrote about my personal approach to managing my own capital which we got a lot of positive feedback from. Given equities would peak a few months later the note was quite timely. With equities significantly lower from their recent peak and the recent bounce in equities, we are taking a slightly different angle to risk management. We are laying out what risk is and what the typical retail equity investor can do to avoid having too much risk should equities begin falling again.
First we need to distinguish between risk and uncertainty. Risk can formally be described as process that is quantifiable with a certain confidence bound related to the sampling size; in other words, a process in which can have statistics. Uncertainty is defined as unquantifiable such as the invasion of Ukraine, because the event is unique and thus has no meaningful prior.
If we look broader at risk it all starts with the ultimate definition of risk which is avoidance of ruin. While being an important concept and something that can be avoided if an investor refrain from using leverage, ruin can also be losing 98% of wealth; it is just not complete ruin. But it is ruin enough that you need a 4900% gain to get back illuminating the asymmetry between gains and losses.
The most normal definition of risk is the variance of some underlying process (for instance a stock) which is a statistically measure of how much a process varies around its mean value. The higher the variance the higher probability of big moves in either direction. Since most retail investors are equity investors, and thus long-only investors, we should care more about the downside risk than the upside risk (gains) as I want as much variance if its lower bound is above zero return.
Focusing on downside risk/returns leads to a concept called semi-variance which only focuses on the returns below a certain threshold, often zero, and describes the downside risk. The problem with this approach is that the underlying assumption is a well-behaved distribution of negative returns. Now, we know financial markets and equities are fat-tailed meaning that we observe many more big moves (both gains and losses) than what the normal distribution would indicated. This means that the semi-variance will underestimate the true risk because of the asymmetry in returns.
These observations have lead to concepts such as conditional value-at-risk which is a fancy word for calculating the average return of the say 1% or 5% worst returns. This measure has many wonderful statistical properties with one of them being that it is less sensitive to the assumptions of the underlying distribution of returns.
A somewhat related concept which is easier to understand is maximum drawdown which is defined as the decline in portfolio value from the maximum value to the lowest value over the entire investment period. Because of the asymmetry of gains and losses, traders focus a lot on this measure and cut losses to avoid big drawdowns or large single period losses (daily, weekly, monthly).
How can the typical equity investor reduce risk?
The typical return investor has limited capital and thus often end up with portfolios holding only 3-5 stocks as minimum commission otherwise would equates to high transaction costs. The first plot shows the returns of a 5-stock portfolio in European equities in which we select randomly five stocks in January 2010 and let them run through time. If one stock is delisted or bought we just place the weight in cash. We do this 1,000 times to the intrinsic variance in outcomes of such portfolios.
A considerable percentage of these 1,000 portfolio end up with a negative return over this 12,5 year period which in itself is remarkable, but the number of portfolios that end with extremely high total returns is also surprisingly high. In other words, a 5-stock portfolio is a lottery ticket with an extreme variance in outcome. The blue line and area represent the median total return path and its variance if these random 5-stock portfolios are blended 50/50 with a the STOXX 600 Index. The striking result is that the median expected return is not changed but total risk (both gains and losses) is reduced considerably. The sharpe ratio, which measures the annualised return relative to the annualised volatility, improves 20% on average by adding an equity market component. So most retail investors can drastically improve their risk-adjusted returns by adding an ETF that tracks the overall equity market without sacrificing the expected return.
If move on to the maximum drawdown concept we see on the first plot how much the maximum drawdown is reduced by adding the equity market to the 5-stock portfolio. All retail equity investors that have a small concentrated equity portfolio should seriously move to a portfolio where the 5 stocks are kept but reduced to 50% of the portfolio with the freed up cash invested in an ETF that tracks the overall equity market.
If an investor is willing to lower expectations for long-term returns, then the ETF tracking the equity market can be substituted with an ETF holding a balanced basket of many different asset classes including government bonds, credit and different types of equities. We use the Xtrackers Portfolio UCITS ETF as an example and should not be viewed as a recommendation but one example of a diversified asset allocation. As the second plot shows the expected distribution of maximum drawdowns from combining 5 stocks with an ETF tracking multiple asset classes is better compared to the other solution combining only with the equity market. The risk-adjusted return is now 43% better than the simple 5-stock portfolio.
Given equities have bounced back in July and so far also in August retail investors have an unique opportunity to bolster portfolios in the case we get another setback in equity markets. Our view is still that inflation will continue to surprise to the upside and that financial conditions will continue to tighten further adding headwinds for equities. At the same time deglobalisation is accelerating adding unpredictable sources of risk to the overall system.
Expectations should be adjusted due to inflation
These classical approaches to reduce equity risk mentioned above hold for normal environments but if we get into trouble with a prolonged inflationary period such as in the 1970s or a deflation of equity valuation among technology and health care stocks then we could get prolonged period of negative real rate returns. We have two periods in US equity market history since 1969 in which it took 13 and 14 years to get back to a new high in real terms.
Our overall theme in our latest Quarterly Outlook was about the tangible world and our bet is that tangible assets will continue to be repriced higher against intangible assets and if we are right investors should consider commodities to offset the risk to real wealth from inflation.
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