Down-market beta, downside capture ratio, and down-market correlation are investment risk measurements that are valued for their ability to assess a portfolio's resilience during bear markets. These metrics provide a window into an investment strategy's long-term risk/reward profile, demonstrating how it might behave in adverse market conditions over time. However, when it comes to short-term volatility, as indicated by high/low short-term return ranges, they may not tell the whole story.
While these metrics are invaluable for understanding a portfolio's broader risk landscape, they primarily cater to long-term frameworks with a higher data point count. The landscape might look significantly different when you zoom into the short-term, where volatility can swing wildly, presenting a unique set of challenges and opportunities.
“Could you sleep at night?”
One effective way to get a better handle on short-term risk is to delve into a portfolio's historical worst 3- and 12- month returns. This data can provide a more tangible feel of what to expect in adverse conditions over a shorter timeframe. It’s prudent to ask your clients a simple yet profound question: “Could you sleep at night if this worst 3- or 12-month return were to happen again?”
If the answer is a resounding no, it might be a cue to reassess their risk tolerance. For instance, if a client is categorized as 'Aggressive,' stepping down to a 'Moderately Aggressive' stance could be considered. This process should continue, adjusting the risk objective and re-evaluating the client's comfort level with the historical worst-case short-term return until a suitable risk tolerance level is achieved.
These insightful measurements can be found on the iQUANT model fact cards and optimizer PDFs, making it easier for you to have an informed discussion with your clients about short-term risks.
A Balanced Portfolio may not always trend a cap-weighted index.
Furthermore, it’s essential to acknowledge that a portfolio's historical worst case short-term return might not have transpired during a broad market downturn. Investment portfolios are often allocated among low-correlated models, some of which might not adhere to cap-weighted broad market strategies. Thus, the worst short-term return of a diversified portfolio might occur in an entirely different market environment.
In conclusion, while traditional risk measurements are critical in understanding a portfolio’s behavior over the long term, they might not sufficiently illuminate short-term volatility. By diving into historical short-term return data and having open discussions with your clients about their comfort levels with worst-case scenarios, you can craft investment strategies that are not only robust but also aligned with your clients' risk tolerance, ensuring a smoother journey towards their financial goals.
When evaluating performance, keep the long term in mind while reminding clients of the best and worst short-term return ranges. While you are responsible for their allocation, the client must understand that short-term volatility is a normal part of the investment process. As a reminder, use the tables and charts on our factcards and portfolio pdfs.