Managing clients’ downside risk

Managing clients’ downside risk

As humans, we are seemingly wired to have a greater aversion to losses than a desire for gains.

As stewards of capital, we are often charged with protecting client wealth, sometimes at the expense of growing it.

John Maynard Keynes once said: “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him”.

In other words, bankers, economists and policymakers seek safety in consensus thinking, knowing that if they are wrong, they will all be wrong together.

During times of negative markets, many wealth managers have found comfort in telling clients that, while their investments are down, they are down less than the benchmark.

On more than one occasion, those same clients have reminded us that they cannot eat ‘relative’ bread, that they are less interested in benchmarks and more interested in how much actual money they have.

When constructing a portfolio, we ask ourselves the following questions: How are we feeling about the current economic backdrop? How is this likely to evolve over the coming months and years? 

How much risk are we willing to deploy in portfolios?

Key Points

  • It is challenging to construct a portfolio in uncertain times
  • Alternative assets can create diversification in a portfolio.
  • Gold is a good diversifier

Traditionally, this translates into how much equity one holds versus how much bond exposure one has.

This would then be distilled into regional and sectoral allocations for equity and corporate or government bonds.

While simplified, this is the traditional diversification one would have used to reduce the risk and hence protect against the downside.

As asset allocation has evolved, we have seen the entry of other asset classes.

This can be divided into property and alternatives.

Property provides portfolios with a stable and regular income (in the form of rental income), which can also, along with the capital, grow over time.

If we close our eyes to current valuations, there are also risks: property is not an asset that can be easily bought or sold and includes a range of expenses in doing so.

While movements in valuation are often gentle, these can be exaggerated by the complicated methods of access.

Alternatives perhaps cover the widest spectrum, from unregulated hedge funds to gold.

Some of the former may in fact provide a higher level of risk than pure equity portfolios.

Some wealth managers have looked to use alternatives as a vehicle to lower overall portfolio risk and hence protect against market downturns.

One exposure is gold, which provides protection in market sell-offs, as it is seen as the ultimate store of value.

Our alternative exposure is looking to produce returns that have a low correlation to traditional asset classes, hence fulfilling our twin requirements of growth and downside protection.

One asset class that is often dismissed as such is cash.