The diversification of your assets across different classes of stocks and bonds as well as alternative investments such as real estate and commodities is designed to protect you against market risks. However, recently we have 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 revered in financial circles. And it’s codified in Modern Portfolio Theory.
Michael Auster: When markets do what everyone hopes, which is to rise, the brilliance of Harry Markowitz’s Modern Portfolio Theory is often celebrated.
Then balances rise, risks appear to be reduced or under control, and financial institutions are widely seen as the true engines of humanity.
Few financial theories have changed the world for the better than MPT. After its introduction in 1952, it helped institutional investors develop their portfolios into higher-yielding areas of the financial markets. This was a profound shift for portfolios historically anchored in the perceived safety of bonds. The higher returns of a diversified portfolio have allowed many companies to do even more good.
Light: And that sounds too good to be true.
Oyster: Much has changed since 1952. We have learned from experience that the volatility of price, both up and down, that represents 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 therein lies a hard lesson that everyone eventually learns. There is a difference between models and markets and ivory towers and Wall Street.
Light: Tell us how.
Oyster: Financial models suggest that low historical correlations between investments across asset classes can help stabilize portfolios during times of market stress. But most institutional portfolios derive almost all of their risk from the vagaries of the stock market. We’ve learned this lesson over and over again, and every crisis seems to make this relationship even stronger.
Observers who bemoan short-term price volatility in institutional portfolios are often rebuked with an elegantly described, but perhaps overly ambitious, description of risk for perpetual institutions that goes something like this:
Risk is not volatility. It is the permanent impairment of capital, a loss that even infinite recovery time cannot recover.
However, if this provided a full description of institutional risk and no short-term volatility ensued, as long as capital was never permanently impacted. Then the investment solution would be simple.
All institutions would invest 100% of their wealth in the US stock market, which has skyrocketed throughout recorded history despite short-term declines over time. If it just could be that easy.
Light: What is the problem?
Oyster: In reality, institutional investment portfolios are structured for the long term, but order-related expenses from these portfolios are much more short-term in nature.
Cross-quarter smoothing helps, but even a short-lived decline in assets can put significant pressure on mission-related funding. The thought of informing the leaders of an organization that they need to find a way to do the same work with fewer dollars could keep anyone up at night.
What is really important? Should we try to reduce volatility or should we reduce downside risk? Stock market losses are often not mitigated by other assets in a “diversified” portfolio. In contrast, a thoughtfully structured, options-based solution can target and objectively eliminate a specific and prescribed loss tailored to a company’s unique needs.
Light: Tell us how this works.
Oyster: Consider this: all other things being equal, a put option is expected to appreciate in value if the underlying stock or index falls. In most cases, when the equity investment falls, the put rises, which can offset losses or even eliminate them entirely.
The problem with puts is that they are expensive. When an investor is inexperienced with options and then considers the cost of hedging risk with puts, they often choose not to proceed after concluding that the risk reduction offered by the put is not great enough to justify the purchase price to justify. 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 at no cost. For example, you can have protection in the form of put protection funded by selling call options. In other words, an investor can trade unlimited upside for downside protection.
Light: What about the risk of bonds?
Oyster: Investors have recently been reminded that many areas of fixed income are far from risk-free and that bonds may not always provide the equity risk mitigation promised by diversification. Certain fixed income ETFs have deep option markets associated with them. The same options-based hedging techniques can be used to mitigate interest rate risk, credit risk, etc.
Light: What’s the future like?
Oyster: In an environment of rising interest rates, persistent inflation and geopolitical uncertainty, institutions face special challenges. Most portfolios pose no greater threat to the asset than the risk of a stock market loss. Certainly, traditional concepts like diversification may be ill-suited to address them. Put options can be expensive, but their cost can be offset by forgoing some of the upside potential, perhaps a small sacrifice if future market returns are lower than in the past.
MPT has gotten us this far, but the investment portfolios of the future can benefit from protection that is explicitly targeted at stock market risk and that can be customized to match virtually any risk or return.