Updated: Aug 6, 2019
A strategy to reduce risk while maintaining your investment portfolio growth potential in uncertain times
Brendan Greenwood, CIM, B.Comm | January 28, 2019
Has your advisor ever said you need to take on more risk to earn higher returns? The simple chart below highlights the increased returns required to recover as your loss grows larger.
Market volatility is not static and without a controlled volatility strategy major market events like the financial crisis of 2008 or the stock market selloff in 2015 could have a serious impact on your investment portfolio prolonging the time it takes to reach your goals.
What is your strategy for protecting the value of your investment portfolio in these uncertain times? How could a constant risk strategy that targets a lower level of volatility benefit your investment portfolio?
Let’s look at a simulated example of what the impact can be on returns when we reduce volatility. Standard deviation is a measure of volatility and explains how much an investment’s returns could deviate from the average. The greater the standard deviation, the riskier the investment. The example below displays the annualized return of the S&P/TSX composite index over a 25 year period and illustrates what happens as we start to remove more and more of the worst and best performing days. By removing more of both the best and worst days we get a surprising result. Annualized returns actually climb from 9.48% to 14.98%.
Maintaining a targeted level of volatility within an investment portfolio has been coined by risk management experts as a “Constant Risk Strategy” and has been adopted by large institutional pension fund investors to protect and enhance returns. A targeted risk level is maintained by reducing exposure to riskier assets when markets are threatening (highly volatile) and increasing exposure to riskier assets when volatility is low.
According to Mark Yamada of Pur Investing in an article published by Advisor’s Edge titled “Rebalancing to a fixed asset mix can be dangerous, the autocorrelation of the VIX is very high. 85% on a monthly basis and 98% on daily basis.” This means that yesterday’s VIX predicts 98% of today’s. In other words, past volatility is a good predictor of future volatility, especially when applying greater weight to more recent volatility.
Quantitative modeling can be used by risk managers to track the persistence of volatility as it fluctuates around its long-term average. Observations are exponentially weighted with more weight given to more recent observations. This helps risk managers predict future movement in volatility and adjust strategic asset mixes accordingly to maintain a targeted level of risk.
How can the average investor access the benefits of a Constant Risk Strategy? You’ll want to work with an advisor who can provide access to investment solutions that employ this strategy.
Brendan Greenwood is an Investment Advisor with Worldsource Securities focused on leveraging technology to provide progressive institutional style investment solutions for professionals, business owners and retirees.
This article is for general and educational purposes only and does not represent investment advice or an offer to sell or a solicitation to buy or hold any securities. It is based on the perspectives and opinions of the writers only and does not necessarily reflect views of Worldsource Securities Inc. Investors should always consult an appropriate professional regarding their particular circumstances before acting on any of the information here. The charts provided are for illustrative purposes only and not indicative of any investments. Investors cannot invest directly in any index. Index returns are for information purposes only and do not represent actual strategy or fund performance. Index performance returns do not reflect the impact of management fees, transaction costs or expenses. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. This material may also contain projections or other “forward-looking statements.” There is significant risk that forward looking statements will not prove to be accurate and actual results, performance, or achievements could differ materially from any future results, performance, or achievements that may be expressed or implied by such forward-looking statements and you will not unduly rely on such forward-looking statements. Worldsource Securities Inc., sponsoring investment dealer and member of the Canadian Investor Protection Fund and of the Investment Industry Regulatory Organization of Canada.