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“If social distancing is successful it will be viewed by most people as unnecessary in retrospect. This is the essence of risk management, and why so few successfully manage risk” – Jess Bost

In asset management, allocation and diversification are the lifeblood of risk management. Your portfolio should include different types of assets to reduce risk. For example, bonds can be a hedge against equity exposure while international investments can be a hedge against domestic exposure. You’re purchasing assets with a low correlation in an effort to reduce systematic risk.

The correlation coefficient measures the strength of relationship between two variables. The range of values is -1.0 to 1.0. Correlation of -1 indicates perfect negative correlation, 0.0 indicates no correlation, and 1.0 indicates perfect positive correlation.

An inverse S&P 500 ETF and an S&P 500 ETF will likely have a -1.0 correlation. An S&P 500 ETF and a bond ETF may have a 0.0 correlation and two similar S&P 500 ETFs will likely have a correlation of 1.

Understanding correlation is critical in risk management. If your portfolio is 50 percent stocks and 50 percent bonds, it’s likely half of your portfolio has a low correlation to the other.

The Downside of Risk Management

If diversification is unsuccessful, most people will view it as unnecessary. The inverse of the quote at the beginning of this blog. This is not an original thought and success is not binary.

The chart below shows a portfolio’s performance from 2010 through 2019.

A 108 percent return in the 2010s would be considered successful by most people. That is, until you compare the performance to the chart below.

You missed out on 81.1 percent of the upside because of diversification.

This is the problem with diversification. In a bull market, diversification can create a drag on performance and can lead to playing Monday morning quarterback.

On the flip side, if you owned the same portfolio from the beginning of 2020 to the S&P 500’s most recent bottom, diversification was successful. While the portfolio was down, it captured just 48 percent of the downside.

Hedging as a Diversifier

Recently, I had a conversation with a friend who was asking about hedging their portfolio. Specifically, they wanted to protect their downside while still capturing the upside.

Most people equate hedging in their portfolio to what hedge fund managers try to do. The allure of hedge funds is they attempt to provide positive returns regardless of index performance. However, this is great in theory, but hard to execute.

Is it possible to build a sleeve of investments to hedge what you own? Absolutely, but it comes at a cost. There could be additional volatility, complicated products, a potential drag on portfolio performance, the actual cost of the hedging products, and the list goes on.

At a simplistic level, through asset allocation and diversification, you are creating a hedge. It may not be in the sense you’re envisioning, but it’s happening.

Final Thoughts

An investor’s ability to weather ‘market storms’ depends largely on how serious they take risk management when the sun is shining. If risk management is an afterthought and implemented only because markets are falling, you’ve missed the point.

I’ll leave you with a quote I feel sums up risk management. In a Forbes article, Brian Portnoy said “Being truly diversified means that there almost always will be a part of your portfolio that is sucking wind.” For most investors, risk management through diversification is a necessary evil. Even if it seems unnecessary in retrospect.