Friday, April 21, 2017

Preparing for market risk - stay diversified across asset classes, factors, and strategies

You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready – you won’t do well in the markets. If you go to Minnesota in January, you should know that it’s gonna be cold. You don’t panic when the thermometer falls below zero.
-Peter Lynch 

Simple advice for any investor. Accept that bad things will happen to markets. You may not know when, where, or how much it will affect markets but it will occur. There will be tail risk. The question is how you deal with it. Simple preparation can come through three dimensions:

1. Asset Class Diversification - The only free lunch of finance. Since you may not have any idea when bad times will come, the easiest solution is to diversify across asset classes that behave different across the business cycle. If a portfolio is concentrated, don't be surprised if there are periods when it will do poorly.

2. Factor Diversification - Look at the factors and structure or diversify. There are macro and micro risk factors. For example, some portfolios will be more sensitive to inflation. Others will be sensitive to the market capitalization. Small cap stocks will have more extreme moves around the business cycle. If you are not sure what you want with respect to factors, then diversify.

3. Strategy Diversification - Since many asset classes will often correlate to one during a crisis, asset class diversification may not be enough or the only solution. A second tier of diversification is through different investment strategies. Managed futures will perform differently during risk-off regimes as opposed to risk-on. Credit strategies will perform differently during different point in the liquidity cycle. Strategy correlations will generally stay lower than asset class correlations when there is a change in the business cycle; however, this may not be the case if there is a financial crisis. 

The performance cost from diversification may be less than the cost of specific tail risk strategies, so it seems as though diversification should always be the first line of defense against a negative market move.

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