Significant stock market and economic risk

Just what is the period of significant stock market and economic risk and how do we manage it?

The objective of the short term component of the portfolio (cash and bonds) is to protect income and capital needs in the event of significant risk and to defer equity sales during periods of low valuation and low market risk, while forcing sale of excess return at high to extreme market valuations.

In other words it is the management of the structure that is most important and this is an investment discipline.

If we look at historical analysis of market risk and return we can define the nature and time frame of historical risk. Actual management of significant risk will depend on the market valuation and underlying economic/earnings cycle.

If we were to ensure that at all times there is sufficient low risk allocation to protect client liabilities and, to defer forced realisations of equity investments, in the event of this level of risk at fair market/economic valuations, a portfolio would be efficiently allocated between short and long term assets in accordance with short and long term financial needs and in accordance with each asset class’s short and long term risk/return profile.

This is an optimisation process, not of the traditional dedicated low risk asset liability modelling kind, but one which incorporates both low risk and equity portfolios in the optimisation process. During periods of excess market risk and return, the period of cover will need to be pushed forward, as excess return and risk is sold at the margin. See the following chart.

Let us assume that the period of significant market and economic risk is the cover we need to have within the portfolio as a basic minimum. As markets move into excess risk and return (advanced economic and market cycles), this level of cover is increased. What is in fact happening is that excess return and risk are being sold and transferred to future consumption. This type of exercise can only be effected in association with asset management valuation and economic analysis. It is also importantly not a timing exercise, since this is capital that is earmarked for consumption.

Importantly, this process also defines the importance of diversification within the portfolio risk/return management process. Diversification in this context is a return management platform, risk management being a consequence of diversification as opposed to a primary objective. The less diversification the fewer opportunities for excess/risk return management at all stages of the portfolio life cycle. The actual return management structure that liability management frameworks provide can also significantly enhance long term return.