Strategy & Practice Management
Focusing on risk to build a more robust portfolio
Harold Kim of Neo Risk Investment Advisors
Feb 5, 2018
Harold Kim, founder and CEO of Neo Risk Investment Advisors, believes that all portfolios must be assembled and managed with an eye towards risk. Kim and his colleagues stress the need for dynamic risk management to improve portfolio performance.
Kim wants to change the way people invest and the way wealth managers provide advice to their clients. Dr Kim, who has degrees from Harvard and Princeton universities in the US, told the audience at the Hubbis Independent Wealth Management Forum in Hong Kong in November: “I want to explain why we think risk is the critical investment variable that you should be thinking about, if you are not already, and how risk-focused investing works and is implemented.”
From classic investment portfolio theory, investing is a trade-off between risk and return, he told the audience, explaining that an optimal portfolio allocation is always a function of an investor’s risk appetite and expected risk and return in the market. Kim noted that a given portfolio cannot remain optimal for an investor if risk changes dramatically—the investor needs to respond to changes in risk by changing portfolio allocations.
Predicting returns is elusive
The history of financial markets demonstrates that return and risk can change significantly through time. “If an investor does not respond to changes in either expected return or expected risk, then the investor’s portfolio will be suboptimal; that is, the portfolio will not be the best portfolio possible.”
Kim continued: “However, we all know that returns are extremely difficult to predict, with an eminent professor once noting that a monkey throwing darts at a list of stocks will choose a portfolio that will perform just as well as or better than one chosen by an active investor. It is very, very hard to predict returns.”
Kim cited an example of research comparing consensus forecasts for the S&P500 since 2000 versus a simple 9% return assumption. Referring to a chart, he noted that “highly paid strategists on Wall Street trying to predict how the S&P500 would perform each year did not do as well as simply assuming equity returns would be 9%. Predicting returns is very difficult. For example, coming into 2017, who thought Asia was going to be up over 30%? Or the S&P500 up more than 16% year-to-date?”
He then highlighted similar problems with forecasts for the 10-year US Treasury yield. “In 14 of the last 16 years, the Wall Street forecast for 10-year yields has been so off that even the predicted directional movement of the yield was incorrect.”
But risk is more predictable
Kim then turned his attention to risk, which he explained is persistent and therefore more predictable. “What do I mean by persistent? If risk in the market is low today, risk tomorrow will most likely be low. If risk is high today, most likely risk will be high tomorrow. That is persistence. Contrast that with returns. If returns are up today, does that mean returns will be up tomorrow? Since we believe markets are efficient, most likely we do not know — perhaps the chance is 50-50 that markets will be up.”
Kim continued with the following insight: “We know that certain portfolio allocations do better in low risk environments, and others do better in high risk environments. So understanding that risk is persistent should allow an investor, by understanding the current outlook, to improve their portfolio allocation and therefore investment performance.”
He presented slides to illustrate the general point that risk is persistent and predictable, and therefore could be used to improve portfolio performance.
Dynamic risk management
“Risk can be managed; there are a variety of tools that exist to manage risk, including hedging, derivatives, factor-based investing and dynamic portfolio allocation” Kim explained.
Kim drew some lessons from the 2008 crisis, the worst financial crisis for seventy years. He challenged the audience: “You can ask yourself, are you happy with your portfolio performance in 2008? Or 2011? Or during some of the other downturns we have had? A risk-focused approach to portfolio management would have mitigated the losses in each of these cases.”
Kim ended the session by characterizing the investment approach used by Neo Risk. “We stress dynamic risk management. We forecast market risk on an on-going basis, and then actively manage the risk in our portfolios by taking into account our view of market risk. The end result is investment performance that is smoother and more robust than a more standard investment approach.”
Founder and Chief Executive Officer at Neo Risk Investment Advisors
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