At its most basic level, investing is an exercise in taking risk and, therefore, having a firm grasp on risk management is essential. One of the challenges associated with investing, as my colleague Erik Ristuben recently pointed out, is that risk does not affect all investors in the same manner. In our work with some of the largest institutional investors in the world, we have found that having an overarching framework for allocating and subsequently managing risk can effectively address these varied perspectives and often makes the difference between investment success and failure.
Here at Russell Investments, our risk management framework is based on 5 core beliefs that are summarized below.
Belief #1. Thoughtful diversification: Effective diversification requires more than simply holding assets that are not perfectly correlated with one another: you first need to identify risks that you can reasonably expect to get paid for taking. For example, we believe that a strong case can be made for a positive return over the long term for the equity, credit and illiquidity risk premia1. The challenge is that the payoff time horizon is difficult to predict. Therefore, we construct portfolios to be diversified as broadly as possible across risk premia that we have high confidence in for a given investor outcome. This helps reduce the odds that the portfolio will be out of favor for an extended period of time.
Belief #2. Meaningful perspective: The typical risk monitoring system metrics provided are often too arcane to be useful to the end user. Therefore, we take the extra step to translate investment risk into terms that are more familiar to the key decision-makers. As an example, the sponsor of a defined benefit plan may be particularly interested in the potential impact on free cash flow and earnings-per-share, while a non-profit views risk through the lens of the potential impact on spending.
Belief #3. Complete tool set: To effectively manage risk you need a very broad tool set. At Russell Investments, we don’t limit ourselves solely to in-house management or single style of investing. We equip our portfolio managers with a broad tool set so they can build their portfolios to meet a particular client’s objectives using the very best strategies and tools available – regardless of where they are sourced.
Belief #4. Implementation: World-class investment strategies can be rendered worthless without world-class implementation. Our team is vigilant about implementation risk and constantly works to reduce potential sources of performance slippage (e.g. excessive transactions costs) or unintended risk (e.g. implementation delay). Excellence in implementation can be thought of as tuning out static so that the true signal from investment ideas doesn’t become distorted.
Belief #5. Meeting the challenge head on: Whether we like it or not, every long-term strategic investment decision has a timing element associated with when that particular exposure enters or exits the portfolio. Our investment team has embraced the challenge of timing risk by considering current market conditions, while also being cognizant of the trap of being too reactionary to short term market events.
Ultimately, the biggest risk any investor faces is the risk of bailing out of a good strategy after a bad stretch of performance. This is particularly pronounced during extreme events in the market. The unfortunate reality is that bailing near the bottom can leave a permanent scar on the portfolio.
Of course, many investors can’t afford to take as little risk as they might like which is why having a framework based on core beliefs such as the one summarized above can help instill the fortitude required to stay the course during market extremes. However, that is only part of the solution. Preventative medicine, in the form of truly understanding your risk tolerance in the first place, often proves more effective than prescribing more patience after a difficult period in the markets.
1 Risk premia, also known as a risk premium, is the return in excess of the risk-free rate of return that an investment is expected to yield. An asset’s risk premium is a form of compensation for investors who tolerate the extra risk – compared to that of a risk-free asset – in a given investment.
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