Pimco has been marketing a new multi-asset fund based on the idea that broad diversification is the best way to avoid tail risk. Tail risk is any extreme market downside move which is not expected with a normal distribution. They have provided a catchy argument that investors have to differentiate the methods used for risk management into two types.
One can be described as just-in-time risk management. This would be the type of response that is an active reaction to an extreme move. We see the market falling and we hedge our exposure. There is a crisis and an investor reacts with some active strategy to diminish downside risk. This is very effect at minimizing the cost of hedging between these extreme events; however, the price of hedging instruments will clearly increase when there is an ongoing crisis. The cost of insurance is high when the house is one fire or when it is hurricane season. Problems arise if the extreme event occurs very quickly. There is little time to react because there may be a jump in prices. Just-in-time risk management can be very costly if there is a surprise event.
The other alternative is to build portfolios with the view that you want to have diversification just-in-case there is an extreme event. Do not keep all of your eggs in one basket. This would focus on buying assets which have the maximum amount of diversification and will be uncorrelated at the extreme. Under this scenario, the best action would be to hold a broadly diversified portfolio. Of course, there may be costs with this diversification because there may be a drag on performance for purchasing negatively or low correlated assets. This cost may be the case with managed futures which does very well during some extreme events but which may have poor performance during other periods of relatively calm markets. if you believe that extremes are few and far between, then you should focus on just-in time risk management. If you believe that extremes occur more often than what most expect the proper course may be to follow a just-in-case asset management program.
This dichotomy is a good framework for looking at building portfolio to protect against downside; however, there needs to be a little more meat on the bone to explain when and how each alternative will appropriate.
One can be described as just-in-time risk management. This would be the type of response that is an active reaction to an extreme move. We see the market falling and we hedge our exposure. There is a crisis and an investor reacts with some active strategy to diminish downside risk. This is very effect at minimizing the cost of hedging between these extreme events; however, the price of hedging instruments will clearly increase when there is an ongoing crisis. The cost of insurance is high when the house is one fire or when it is hurricane season. Problems arise if the extreme event occurs very quickly. There is little time to react because there may be a jump in prices. Just-in-time risk management can be very costly if there is a surprise event.
The other alternative is to build portfolios with the view that you want to have diversification just-in-case there is an extreme event. Do not keep all of your eggs in one basket. This would focus on buying assets which have the maximum amount of diversification and will be uncorrelated at the extreme. Under this scenario, the best action would be to hold a broadly diversified portfolio. Of course, there may be costs with this diversification because there may be a drag on performance for purchasing negatively or low correlated assets. This cost may be the case with managed futures which does very well during some extreme events but which may have poor performance during other periods of relatively calm markets. if you believe that extremes are few and far between, then you should focus on just-in time risk management. If you believe that extremes occur more often than what most expect the proper course may be to follow a just-in-case asset management program.
This dichotomy is a good framework for looking at building portfolio to protect against downside; however, there needs to be a little more meat on the bone to explain when and how each alternative will appropriate.
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