Spreading your assets over different classes of stock and bonds, as well as alternative investments such as real estate and commodities, is supposed to buffer you against market risk. Lately, though, we’ve seen both stocks and bonds take a hit, which is very unusual. Michael Oyster, chief investment officer of Options Solutions in Chicago, has a better answer.
Larry Light: Diversification is worshipped in financial circles. And it is codified in Modern Portfolio Theory.
Michael Oyster: When the markets are doing what everyone hopes they do, which is rise, the brilliance of Harry Markowitz’ Modern Portfolio Theory is often celebrated.
Then, account balances are rising, risks are seemingly declining, or under control, and financial institutions are widely viewed as true engines of humanity.
Few financial theories have effected such positive change in the world as MPT. After it was introduced in 1952, it helped institutional investors evolve their portfolios into higher returning areas of the financial markets. This was a profound shift for portfolios that historically were anchored in the perceived safety of bonds. The higher returns of a diversified portfolio have enabled many organizations to do even more good.
Light: And that sounds too good to be true.
Oyster: Much has changed since 1952. We have come to learn through experience that the volatility of price, both up and down,, which is the measure of risk in the MPT model, is not really practical or even relevant.
The risk that people really care about is the risk of loss, and herein lies a hard lesson that everyone ultimately learns. There is a difference between models and markets and ivory towers and Wall Street.
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Light: Tell us how.
Oyster: Financial models suggest that low historical correlations between investments of different asset classes can help stabilize portfolios during periods of market stress. But most institutional portfolios derive nearly all their risk from the whims of the stock market. We have learned that lesson again, and again, and each crisis seems to make this relationship even stronger.
Observers who bemoan short-term price gyrations in institutional portfolios are often rebuked with an elegantly described, but perhaps overly aspirational, description of risk for perpetual institutions, which goes something like the following:
Risk is not volatility. It is the permanent impairment of capital, which is a loss that even an infinite amount of recovery time cannot repair.
If, however, that provided a full description of institutional risk, and no amount of short-term volatility was consequential so long as capital was never permanently impaired. Then the investment solution would be simple.
All institutions would invest 100% of their assets in the U.S. stock market, which throughout all of recorded history has ascended skyward over time, despite short-term declines along the way. If only it were that easy.
Light: What’s the problem?
Oyster: In reality, institutional investment portfolios are structured for the long term, but mission-related spending from those portfolios is much more short-term in nature.
Multi-quarter smoothing helps, but even a short-lived decline in asset values can place substantial pressure on mission-related funding. The thought of informing the leaders of an organization that they will have to find a way to do the same work with fewer dollars might keep anyone up at night.
What is truly important? Should we seek to reduce volatility, or should we reduce risk of loss? Stock market losses are often not tempered by other assets in a “diversified” portfolio. By contrast, a thoughtfully structured, options-based solution can target and objectively eliminate a specific and prescriptive loss that is customized to an organization’s unique needs.
Light: Tell us how this works.
Oyster: Consider the following: all else being equal, a put option is expected to increase in value when its underlying stock or index goes down. In most cases, if the stock investment is declining, the put is advancing, which can offset or even fully eliminate losses.
The problem with puts is that they are expensive. If an investor has no experience with options, and then considers the cost of hedging risk with puts, they often choose not to move forward after deducing that the risk mitigation provided by the put is not great enough to justify the purchase price. For many, this is the last time they consider options as a hedge and the story ends.
Light: But that’s not the end of the story.
Oyster: With a little creativity, a hedge constructed with options can provide a desired level of risk protection with no cost. For instance, you can have a hedge in the form of put protection, which is financed by the sale of call options. Said a different way, an investor can trade unlimited upside potential for downside protection.
Light: What about with bonds’ risk?
Oyster: Recently, investors have been reminded that many areas of fixed income are far from risk-free and that bonds may not always offer the equity risk mitigation that was promised by diversification. Certain fixed-income ETFs exhibit deep options markets associated with them. These same options-based hedging techniques can be applied to mitigate interest rate risk, credit risk, etc.
Light: What’s the future look like?
Oyster: In an environment of rising interest rates, persistent inflation and geopolitical uncertainty, institutions face unique challenges. Most portfolios exhibit no greater threat to asset values than the risk of stock market loss. To be sure, traditional concepts like diversification may be ill equipped to address them. Put options can be expensive, but their cost can be offset by forgoing some of the upside, perhaps a small sacrifice if future market returns are less than in the past.
MPT has brought us this far, but the investment portfolios of the future may benefit from protection that is explicitly targeted to stock market risk and that can be customized to meet virtually any risk or reward that concerns.