The past few weeks have been dominated by news reports about tornadoes that have ripped through Oklahoma, causing devastation in their wake. People have died, personal property has been lost, and communities have been torn apart. While there are things that one can do to prepare for a tornado, at times, these activities are not sufficient and loss does ensue. What about those who actively choose to chase tornadoes? They put themselves in harm’s way in pursuit of a ringside seat. While tornado chasers often say they can model how a tornado evolves and, therefore, place themselves on the safe side of the storm, the loss of three prominent storm chasers suggests that even the best planning at times fails.
It would seem there are parallels here for investors. Investors will face exogenous risks, ones that they can’t control but may be able to mitigate. In cases where risk is actively being sought, tools are needed to assess and manage the risk, to help reduce worst-case outcomes.
In the past, investors had relied on asset liability modelling to help them set an asset mix strategy that meets their return objectives with the fewest foreseeable problems (or value at risk). Asset liability models, while valuable, are just one tool for understanding risk and its potential outcomes. Returning to our tornado chasers, their basic premise is that their weather modelling systems might be wrong, and therefore, when chasing a storm, they place themselves at a crossroad, where possible, to provide four exit strategies.
Similarly, investors have developed additional quantitative risk management tools. It is not uncommon for an investor to look at conditional value at risk (the average of the worst-case outcomes), to understand when things go wrong, how bad that might get and whether or not they can withstand the adverse scenarios. Stress testing using different economic and market environments is another way that investors can better understand how a particular asset mix might behave. Investors who have more robust risk monitoring systems and strong governance can choose to monitor certain risk factors and adapt their asset mix accordingly.
While tornado chasers, where possible, will park themselves at a crossroad in order to provide the most amount of flexibility to stay safe when the tornado does hit, investors can’t park a portfolio and must actively manage it on an ongoing basis. Is there a similar action investors can take to provide the same amount of protection and flexibility?
One such action is to add diversity to the asset mix. That is, building a portfolio that derives its risk and return from a number of factors including the equity risk premium, but not limited to it. Other risk factors that could form part of a diverse portfolio include credit, illiquidity, inflation, term, currency and skill. This means building a portfolio of not just equities and bonds, but including private equity, alternative credit sources, real assets (real estate, infrastructure, timber, agriculture), various hedging strategies and absolute return strategies. The basic premise is that it is impossible to forecast all potential outcomes, but by adding more sources of risk and return, you have the greatest likelihood of achieving your goals and performing in most economic and market environments.
Given that the potential tool box is rather large and, in many cases, requires a lot of time and effort, investors have to make a choice. One way to determine which of these makes the most sense is to ascertain whether the investor is managing the portfolio for an expected outcome or a worst-case outcome. As we have seen with our tornado chasers, even those with experience can get it wrong with dire consequences. Investors should engage in only those asset classes they understand and can monitor.