The risk of a portfolio losing money comes from various angles. Micro risk (small localised problems with the individual company in which you buy shares) and macro risk (larger more global issues that can effect entire sectors and geographies). Micro risks are less of a problem for most portfolios because they can easily be diversified – if a company makes up 3% of a portfolio and the very worst case scenario comes to pass (the investment becomes worthless), the impact is 3%. Macro risks will be more painful.
Macro risks are always present: natural disasters, wars, financial crises large currency exchange rate fluctuations and so forth. Currently they are abundant: Ebola in West Africa; escalating tensions in Ukraine and the Middle East; economic frictions in the Eurozone; a possible tapering of quantitative easing (QE); or an increase in central bank interest rates to name but a few. The bravest of commentators may try to predict which of these issues is most likely to explode and what the potential fallout will be. The only certainty is that these predictions will be inaccurate.
So how to allow for these risks, and how to manage them within a well-diversified portfolio? The most prevalent academic approach is to look at historic correlations between individual stock prices and assume that these correlations will hold going forward. There is a logic to this, but only if the cause of the next market correction is correlated to the last. This is unlikely to be the case. It is like driving by looking in the rear view mirror.
An alternative is to take a less academic, but more practical, forward looking approach to managing macro risk. Do not try to predict the cause of the next market correction, just try to envisage as many plausible (but painful) future scenarios and assess the portfolio, qualitatively, in these environments. Go through this “risk register” and assess whether each scenario is likely to hurt each individual company a lot, a little, not at all, or in just a few cases might actually help.
The aim of such an exercise is to avoid situations where the majority of the stocks held in a portfolio would be heavily impacted by one macro risk – you don't want your soldiers lined up so that one bullet, however unpredictable a direction it comes from, will kill them all. And, ideally, an investor is able to find a few investments that benefits from each difficult situation. This both limits the losses of the portfolio, but also means that the stocks that have a positive price reaction to the event can be sold to provide liquidity to invest in other companies that have become more attractively priced.
Take a sharp spike in oil prices as an example. Thus far, current events have had little impact on oil prices. But what if energy markets followed history’s pattern, and unrest leads to oil prices at much higher levels? A majority of global stocks will fall between the “hurts a lot” and “hurts a little” boxes (as energy is a substantial cost for most businesses). You might place oil majors in the “neutral” box – short term, they should be able to profit from selling reserves at a higher price, but longer term replacing those reserves will have become more expensive. In the positive box you would place producers of oil substitutes (gas producers and other alternative energy companies).
Interestingly, gold (and to a lesser extent gold mining stocks) are examples of investments that looks positive in an array of extreme scenarios. As a result, you may well find gold is an attractive way of getting a degree of “portfolio insurance”.
By taking this “what if” approach to diversification, you will have avoided the very difficult task of trying to predict future events, but will have produced a portfolio that ought to be robust in many different future environments.
To some this may seem too pessimistic an approach, but when when a macro-lead disaster tears through the market, this may well just be a positive.
