Investing Basics: How To Reduce Tail Risk In A Diversified Portfolio

When building a portfolio, retail investors typically seek to generate the highest possible return at a certain desired risk level. More often than not, people try achieve this by acquiring diverse stocks from companies with varied market capitalizations that operate in different economic sectors.

Sometimes, bold investors also diversify geographically, placing some bets on European, Asian or Latin American stocks. For their part, risk-averse investors often go for bonds, fixed-income mutual funds and other safe harbor investments.

Diversify

None of these strategies are truly diversified: when the markets sell off, they can all go down together, said Don Steinbrugge, Managing Partner at Agecroft Partners.

“A portfolio comprised by 60 percent equities and 40 percent bonds is not really diversified. Institutional investors get a little bit more sophisticated in building out their asset allocation. So, most large pension funds or endowment funds will try to create an asset allocation with a high risk-adjusted returns,” he told Benzinga.

In the process of constructing a strong portfolio, investment advisors consider three items, Steinbrugge said:

• The returns different sectors of the equity and fixed-income markets offer, assessing valuations.
• The risks associated with different investments, as measured by volatility  or the standard deviation of returns over time.
• How these factors move in relation to one another, expressed as market correlation.

Once these factors are determined, software can unravel what the optimal asset mix, Steinbrugge said: "What will give you the highest return for the desired level of risk?"

This strategy tends to generate strong returns until there is a major sell-off. Returns are suddenly and unexpectedly negative; volatility increases substantially; and correlations tend to rise, meaning that asset classes investors expected to move in different directions start moving in the same direction.

Tail Risk

The worst-case scenario is when all three  vents occur simultaneously, causing a portfolio to decline significantly more than expected, Steinbrugge said.

“This tail risk is what we saw in 2008.”

It's fundamental to understand what the tail risk in a portfolio looks like. "You don’t want to have to sell when everything else has already sold off,” Steinbrugge said. “The key to a strong portfolio is being able to ride out any major, prolonged market selloff.”

But, how can investors reduce tail risk? 

There are a couple of methods, Steinbrugge said:

• Build a more conservative portfolio.
• Create a portfolio with diverse strategies to ensure correlations don’t surge when markets sell off; some of these are CTAs, direct lending, market neutral equity strategies, volatility arbitrage and reinsurance.

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