Risk Management as Important as Return on Investment

Advice to the Advisors

Sheaff Brock Investment Advisors | Risk Management for Performance Outcomes

Risk Management as Important as Return on Investment

You might say risk management is even more important than return, asserts Sheaff Brock Managing Director Dave Gilreath. In the long run, he believes, risk management can lead to good investment outcomes. And, while nonprofessionals invariably focus on return, expecting their advisors to “beat the market,” that expectation, he feels, is essentially flawed.

As a recent BlackRock study on market upside/downside demonstrates, “the preponderance of evidence suggests that market timing is difficult and rarely adds value.” Instead, emphasizing “low capture ratios” may offer a better chance for outperformance of the markets. The benefits of downside risk mitigation are grounded in simple math, BlackRock’s Director Mark Peterson explains; it requires bigger gains to make up for drawdowns. (As a simple, yet powerful example of this principle, Gilreath explained in an interview with our Institutional editor, if you lose 50% of your money, you must make 100% just to catch up!)

As of this posting, investors are still tending to be risk-averse, Gilreath notes. At some future point, however, he predicts they may become “risk-greedy.” As an advisor, of course, one can ill-afford to become risk-greedy. This is the wrong time to accept lower quality in exchange for higher yield, Gilreath explains to advisors. Instead, this could be the time to become increasingly fluent in options and REITs.

BlackRock’s Peterson thinks investors may not be “getting it.” It is his opinion that, in an environment characterized by higher volatility and rising correlations, investors should ideally be looking for other ways to minimize risk, introducing less-correlated asset classes and emphasizing less-volatile instruments and funds. Instead, he laments, we see exactly the opposite, with a rotation into riskier funds.

A capture ratio of 1 means a portfolio is moving in sync with the market at large. An upside capture ratio above 1 and a downside capture rate below 1, BlackRock explains, would represent manager skill. But, he feels, rather than chasing higher upside capture ratios, emphasizing lower downside capture may be a more worthwhile trade-off in the long run.

How low do you go? “During the last cycle, in which the S&P 500 fell 51% and then rebounded 221% (during the financial crisis and subsequent recovery), a capture ratio for large-cap stocks of between 50% and 75% would have been optimal,” the BlackRock study concludes.

As financial advisors, Gilreath cautions, it’s important to understand that your clients’ expectations, invariably focused on return and on expectations that you’re there to help them “beat the market,” are essentially flawed. In the long term, Gilreath suggests, risk management—for both your clients and for the health of your practice—is going to prove as important as return on investment!

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