*This is the second of a multi-part series focused on investment philosophy, strategy, and practices*
In my previous post exploring the title question above, I reflected on the dual nature of my role at Alesco Advisors: as Staff Economist, I often analyze broad economic and market trends that investors have little control over; as Portfolio Manager, I work within a team that builds and manages portfolios for our clients, applying our investment philosophy to make decisions that are very much within our control.
While the uncontrollable trends of markets and the economy capture headlines, it’s the decisions within an advisor’s control that stand to add the most value for a family or institution pursuing their financial goals. Some of the most important choices an advisor can make involve managing risk.
Part one of this series covered strategic asset allocation and discussed its importance to risk management. But advisors can and should be actively managing risk in other ways, and investors should understand how an advisor’s philosophy, strategy, and practices function to do so.
Managing the Obvious: Investment Risk
Risk is an inherent reality for investors seeking to benefit from participation in capital markets. When investors think about the most obvious forms of investment risk, concepts such as volatility or capital loss typically come to mind.
Given the importance of asset allocation to risk management, one might think that the best way to manage investment risk is to adjust allocations in advance of market movements. For instance, if stocks “look risky”, an advisor could reduce their equity holdings in favor of bonds or cash. This amounts to market timing, which has a track record of inconsistent, unreliable, and sometimes perilous results.
The drawbacks of market timing efforts are thoroughly researched, which leads us to the practice of portfolio diversification as a more reliable alternative for managing investment risk. By not placing all our eggs in one basket, we reduce the impact of temporary or permanent losses from a single asset and increase the opportunity to capture more stable returns from a variety of sources.
Diversification is best achieved by holding a broad mix of assets that are expected to perform differently in a variety of market and economic environments. This entails exposure to a variety of sectors, sizes, styles, and geographies within a portfolio. One seemingly obvious way to achieve this is by using diversified funds, such as mutual funds or exchange traded funds (ETFs), whose underlying holdings are typically numerous and often varied depending on the intended strategy.
But simply holding a combination of diversified funds does not necessarily constitute thoughtful diversification. The market is vast and complex, and an advisor’s strategy should reflect that by ensuring diversification both among and within asset classes. There are two common potential pitfalls I have identified with seemingly well-diversified portfolios that utilize diversified funds:
Alesco constructs client portfolios with a focus on broad diversification to help manage the risk posed by uncertain economic and market conditions in the future. Consistent with our overarching investment philosophy, we start by determining a strategic asset allocation that works for each client. We then identify the specific blend of market segments and investment characteristics we seek exposure to and determine how to most effectively construct diversified portfolios reflecting this blend of segments and characteristics. This leads us to use diversified funds as the building blocks for client portfolios that are diversified both among and within asset classes.
But the work doesn’t stop there—we actively apply sophisticated empirical modeling and analysis to scrutinize the underlying holdings within these funds and ensure that our diversification efforts avoid the unintentional pitfalls outlined above. In this way, we ensure our client portfolios embody our investment strategy and reflect thoughtful diversification. We believe this practice to be the best way to manage investment risk and help our clients achieve their financial goals.
Managing the Less Obvious: Process Risk
The investment risks inherent to participation in capital markets are vital for advisors to manage. But an equally important and less obvious source of risk lies within investors themselves.
Investors are required to make decisions about many factors that are within our control (such as managing investment risk), and the quality of the decision-making process we use dictates the effectiveness of those choices. As much as we’d all like to imagine ourselves as intuitively rational thinkers, human intuition is inherently vulnerable to certain behaviors—such as overconfidence, confirmation seeking, and recency bias—that can cloud our judgement.
Take for instance the waning days of 2022 when the S&P 500 was down nearly 20% from where it started the year, and the overwhelming opinion of economists and market analysts indicated a recession was in store for the U.S. economy in 2023. The feeling of investors was largely dour based on their recent experience, and an advisor who put too much confidence in the accuracy of market forecasts might have felt encouraged to “manage risk” by reducing exposure to the stock market.
The truth is, no matter what anyone feels, no one can make consistent accurate predictions about market performance in the near term. Indeed, the advisor above who reduced portfolio exposure to stocks would have missed out on fully participating in the S&P 500’s 26% rally in 2023 and the subsequent 28% year-to-date return so far in 2024. Without a disciplined decision-making process informing a long-term view grounded in empirical data and sound analysis, important choices regarding risk and portfolio management can easily fall prey to innate biases that impair outcomes.
Social science research shows that it’s impossible to completely rid the human mind of these biases, but it also reveals a potential path for surmounting the obstacles they pose. It starts by acknowledging potential intuitive biases when and where they might arise. Only then can we employ analytical solutions to overcome them.
When making important investment decisions, Alesco focuses on actively identifying biases and using disciplined, data-driven strategies to minimize the risks they pose. We maintain a long-term analytical view on markets informed by empirical evidence, not gut feeling or transient events. This ensures we work toward achieving client goals by following a diligent decision-making process and seeking to avoid the pitfalls inherent in human judgement.
We believe that this practice sets us apart and helps us manage both the more obvious investment risks and the less obvious process risks, giving our clients the opportunity to fulfill their financial goals.
The content in this article is provided for informational purposes only and should not be construed as personalized investment advice. The data and information used in the preparation of the article are obtained from third-party sources believed to be reliable, but Alesco Advisors does not guarantee the accuracy, completeness, or timeliness of the data and information. Past performance is not indicative of future results.