The panic premium

FEAR has a creeping, corrosive effect on investment returns. Angst-ridden investors pay explicit costs in the name of risk reduction (adviser fees, product margins), and succumb to self-defeating practices that carry implicit costs. Common causes of stress-related impact costs are over-insurance, excessive intermediation, the flight to quality and failure to properly discount longevity. Those factors affect all investors.

The first facet of over-insurance involves diversification below the risk budget. That happens when investors reach for a solution that feels safe rather than working systematically to align their portfolios with their actual risk tolerance. The advantage of a higher risk tolerance is that it expands the opportunity set available to investors. But we tend to overreact when fearful. By following this impulse we tend to forego the opportunity for enhanced return.

Over-insurance also involves excessive investment in portfolio protection. Since institutional investors typically obtain that insurance through buying put options, the implied volatility (a measure related to the overall skittishness of the market) provides a way to measure the costs of over-insurance. In that regard note that institutional demand for portfolio protection usually increases after market shocks and, by implication, after the price of insurance has been marked up already.

Bonus smoothing is a recurring source of over-insurance for the retail investor. Smoothed bonus products – which offer graduated return distributions – are often sought by investors looking to avoid the volatility of market returns. Such products are suitable in risk-sharing contexts but are generally a poor risk-management tool for an individual investor. That’s because they systematically dilute the time diversification of investors with long horizons while subsidising the participation of new entrants in bear markets. Newer entrants then end up departing the product during bear markets.

Retail investors are familiar with the principle of diversification. However, they sometimes over-diversify their portfolios by including too many instruments. Effectively they diversify away a significant portion of their exposure to the upside, as the contribution of each outperforming asset is likelier to be offset by an underperforming asset in the same portfolio. Bottom line the nominal difference in assets is offset by the correlation between them. The same problem occurs when spreading investments between different portfolios. If the investment strategies of the respective portfolios are tightly correlated (as they often are) that leads to an erosion of the risk-spreading benefit.

Flight to quality occurs when investors seek a safe haven in perceived low-risk assets. This is motivated more by a fear of risk than a change in the investor’s actual risk appetite. Investors, for example, may sell out of “risky” small-capitalisation companies or “lower quality” companies in a way that perpetuates the cyclical performance of the strategies. In addition, an opportunity cost arises when investors require excessive confirmation before (re)entering these risky segments. Because the surest confirmation is a price rally, cautious investors wittingly pay stress insurance in the form of forfeited participation in the initial phases of the recovery. Additionally entry after the initial rerating provides less of the diversifying benefit – which is ironic, given the stress-assuaging properties of diversification.

Longevity risk is the danger an investor outlives his retirement savings. That risk has increased with the enhanced life expectancy of the economically active, as well as the switch from defined benefit to defined contribution retirement plans.

For example, excessive risk aversion creeps into the retirement plans of young savers who invest in the default company retirement plan. Usually, a core corporate plan would be tailored around the profile of the average employee, whose risk budget would make room for less exposure to risk than that of the younger employee. That error can also occur outside of employment settings, where young investors choose boilerplate options from financial advisers.

Older investors under-budget risk when they sell completely out of risky assets at retirement. As a rule of thumb, that flight from risk was handier when life after retirement was shorter. Today, the longer expected retirement duration affords more leeway for exposure to risk – what’s called time diversification. Not only does that create an opportunity for improved returns but the demands of a longer life after retirement also impose the imperative those returns be actively sought.

A more attractive alternative is provided by dynamic asset allocation strategies, which have been widely used by institutional managers and are available to retail investors through variable asset allocation unit trusts. Typically, such funds alleviate risk by selling out of equity as markets weaken. They manage the asset allocation process on behalf of the investors, who would otherwise have to do it themselves by selling units. Since asset allocation funds have similar fee structures to equity only funds, investors have an opportunity to professionalise the asset allocation at no additional cost.

There’s no single cure to curbing the price for peaceful sleep. But it begins with the disciplined adherence to a systematic management of risk. Then comes the acceptance your best-suited portfolio has an unshakable residual risk. And then living with it.

NEIL HORNE

H1 Capital

HORNE is an investment manager at H1 Capital. His professional background includes equity and risk management. H1 Capital is an independent portfolio manager.