Rita Mayer-Sommer from Deutsche Bank’s Risk Engineering team explains how investors can use their risk tolerance as a source of opportunity
Life must be understood backwards […] but lived forwards.” Søren Kierkegaard found simple words on the connection between time, insight and action – and yet it is anything but trivial to understand the past, and even less to draw conclusions for the future from it. The current crisis has demonstrated how an abundance of information and opinions can blur our views and impede our ability to act with purpose.
The very nature of risk is to be surprising – only in retrospect do events and their consequences appear obvious. For the investor, this implies: market downturns or rallies can begin at any moment – even with comprehensive information, it is impossible to predict their timing consistently. Additionally, significant market moves are generally accompanied by high volatility (and low liquidity), thus complicating the adequate implementation even of “perfectly timed” decisions, which in turn leads to further losses or opportunity costs. Consequently, market timing is both an expensive and unreliable risk management method over the long run. Investors’ long-term success is defined by the balancing act between opportunities and risks while maintaining the ability to remain invested, letting returns compound over time – regardless of market events.
“The very nature of risk is to be surprising – only in retrospect do events and their consequences appear obvious”
The goal of risk management is to protect investors from a flight to cash, whether forced or deliberate, and offer as much opportunity as possible in reward for their risk tolerance. It should also offer a long-term economic advantage, like any type of insurance – even if over specific short time frames it might appear particularly “expensive”.
This makes the choice of risk management method a crucial decision for every investor. Market timing can cause opportunity costs due to discrepancies between long-term predictions and medium-term developments. On the other hand, while remaining completely passive without adjustments of the investment allocation may be systematically efficient over the long term, this is only advantageous if, and only if, investors can stomach any kind of market event without changing their allocation. The market downturn in March 2020 impressively demonstrated how the remarkably synchronous shocks to financial markets and the real economy could affect the liquidity requirements of long-term investors. Both 2008 and 2020 are clear reminders that risk diversification alone is not sufficient in order to avoid excessive losses during market panics.
Complementing diversification, systematic risk management can reduce downside risks more reliably and economically, resulting in more robust portfolio outcomes. Systematic risk management methods, based on quantitative market insights, can however be designed in various ways. Managing risk by changing portfolio allocations through dynamically adjustable futures exposure can be very costefficient in moderate markets, but causes issues similar to those of market timing during volatile periods, leading to concentrated opportunity costs. Alternatively, risks can be mitigated through the systematic use of options while keeping the underlying portfolio as stable as possible. Such an approach requires a recurring investment of an “insurance premium” in order to pursue the risk reduction objective; in return, a continuous enhancement of upside participation can be achieved.
To some investors, risk management seems like a cost – however it should rather be seen as an investment, enabling higher market exposure without increasing portfolio risk. Metaphorically speaking, portfolio protection strategies bear resemblance to vaccines which hopefully, despite potential side effects, will enable our return to normality and the range of possibilities it offers.
Our Risk Return Engineering (RRE) team advises investors on the risk management approach adequate for meeting their goals – keeping in mind that only tolerated risks can turn into opportunities.
Rita Mayer-Sommer is part of Deutsche Bank's Risk Engineering team.
This article originally appeared in our client magazine WERTE 23, "Acting with purpose".