Allocating Dollars vs. Allocating Risks

At High Country Capital Management we believe allocating dollars and allocating risk are different concepts. According to Invesco, Ltd., with a traditional “balanced” portfolio of 60% stocks and 40% bonds, as much as 90% of its risk could be derived from the stock allocation. This means a decline in the stock market could have a much larger impact on a portfolio than expected. As we have painfully seen twice in the last decade, the stock market as measured by the S&P 500 Index has declined over 49% on both occasions. From 2000 – 2002 the S&P 500 declined 49% and during of bear market of 2008 – 2009 the index declined 57%. As a result of these drops, many investors’ portfolios exposed their true risk and investors experienced much more pain they anticipated.

Although the equity markets are well off their 2009 lows, they continue to demonstrate extreme volatility. As the art and science of constructing portfolios has evolved, HCCM has tried to remain at the leading edge of these innovations. There is a sophisticated approach that applies the important balance of managing risk and reward by attempting to measure how much each risk each asset contributes to a portfolio. That calculation is then used to decide how investment dollars should be allocated. This is known as “risk budgeting” and this approach may limit the effect that one underperforming asset such as stocks can have on the performance of the overall portfolio. The goal is to build an all weather portfolio that can perform well in different economic environments. Examples include inflationary, recessionary, growth, and slow growth. One method to help achieve the objective of weathering these different environments is to include alternative asset classes and alternative investment strategies as part of our risk budget. Alternative asset classes include commodities, real estate, and currencies. Alternative strategies include the ability for a fund manager to sell short assets which can generate positive returns when a specific asset is declining in value.

We use correlation data to estimate the short and long term movement among assets to construct portfolios. Using assets and strategies that don’t move in synch with each other can help to fully diversify a portfolio..

Key Points

• Incorporating Risk Budgeting into portfolio construction enhances the approach to asset allocation
• Allows for allocation of risk to more productive source of return while helping to diversify overall portfolio risk
• Adding alternative assets to a portfolio’s mix may increase the portfolio’s overall risk/return profile with higher expected returns and lower overall volatility