3 Strategies for Reducing Risk in Portfolios -Dlight News

Strategic changes to an investment portfolio can often serve as return enhancers. But they can also be viewed as risk reducers. Whether market conditions have changed or a client’s risk tolerance has shifted, there are tactical and strategic options for adjusting a portfolio’s risk profile. Here are three portfolio strategies to consider, along with the types of market environments that may be favorable for each one.

Strategy 1: Buy and Hold

When reducing risk in investment portfolios is a lead priority, the buy-and-hold approach could be beneficial for some clients. With a buy-and-hold strategy, a balanced equity (e.g., 60/40 stock/bond) portfolio would see a decrease in risk for every month, quarter, or year of equity market depreciation. Why? The equity portion would continue to decline in size relative to the fixed income allocation—potentially ending up somewhere close to a 50/50 or 40/60 portfolio after a period of weakness in equity markets.

Your client would end up with a portfolio that takes on the risk profile of a more conservative allocation, helping to preserve wealth on the downside. Buy-and-hold strategies tend to outperform simple constant mix approaches (see below) in up and down markets.

Strategy 2: Constant Mix

The constant mix is a “do something” strategy. It’s often a fitting move for clients during volatile periods, such as right after a financial crisis. Considered the simplest form of rebalancing—and the one employed by many advisors—this strategy involves rebalancing to an increased equity weight during periods of weakness and selling after periods of strength (buy low, sell high).

This way, you can keep the portfolio’s risk profile generally constant through time, as the mix between equities and fixed income won’t drift too far from the strategic weights. You can also clearly explain to clients the value from a risk-reduction standpoint.

This portfolio strategy is popular for a reason: Most market environments are characterized by volatility, and when you include risk in the equation, it can be a prudent rebalancing option.

Strategy 3: Constant Proportion Portfolio Insurance

The rebalancing strategy known as constant proportion portfolio insurance (CPPI) requires more explanation for clients who could benefit from it. Although CPPI is a bit more complicated than the above options and one of the most underused rebalancing methods, it can be effective. It includes a floor value, a multiplier, and the use of two asset classes: risky assets (equities) and lower-risk assets (cash or Treasury bonds).

To get a sense of how CPPI works, consider this example:

Your client decides to allocate $100 to a portfolio and denotes $75 as the floor. The allocation to the risky asset at inception is determined by the multiplier times the difference in the portfolio value and the floor. Here, let’s assume a multiplier of 2: 

• The allocation to equities would be 2 × (portfolio value – floor) or $50 at inception.

• If markets decline over the next year and the portfolio level reaches $95, your client would rebalance the equity portion to $40 (2 × [$95 – $75]).

If fear grips the market and the portfolio drops to the floor, you would allocate all proceeds to the lower-risk asset. Consequently, the stock allocation will be dynamic and will increase (decrease) along with the appreciation (depreciation) in stocks at a faster pace than if you had used a simple buy-and-hold strategy. The main difference between the two strategies is the multiplier and the incorporation of a floor value, also called the insurance value.

For this strategy, you’ll want to let the client know that in strong bull markets, each successive increase in equities results in the purchase of more shares. In severe bear markets, the strategy can provide downside protection because the floor value insulates and provides insurance against large declines in value. Oscillating markets and those characterized by severe short-term reversals, however, can wreak havoc on a CPPI design. In that case, its return payoff is the opposite of a constant-mix strategy.

Staying the Course

Adhering to a well-thought-out investment strategy is generally the best course of action over time for many investors. In my experience, those who have tried to play the game of chasing returns and constantly rotating through positions have often found that their portfolios underperform compared to the portfolios of investors who simply stayed the course.

You’ll likely find, however, that clients often struggle with grasping the concept of needing to sit tight for now. In almost every other aspect of life, we are taught that reaction in the face of perceived danger (a potential recession, perhaps) is necessary. Sitting tight is not something that comes naturally, especially when the perceived danger involves future cash flows and retirement.

This is where your role becomes critical. By walking your clients through the options and the reasoning behind your recommendation, they’ll realize they can count on you to make informed decisions during market disruptions and over the long haul.

Reducing Risk in Investment Portfolios

Over time, portfolio allocations can significantly stray from their target weightings, making strategies like the ones discussed here an important part of the investment management process. Regularly considering the options available and how they’ll play out in different environments presents an opportunity to show clients how the work you do—along with a diversified portfolio—aims to protect their assets, improve their performance, and reduce risk.

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Editor’s note: This post was originally published in November 2019, but we’ve updated it to bring you more relevant and timely information.