Managing Mutual Fund Risk

The standard approach to managing risk with mutual funds is so entrenched in the minds of investors that any alternatives aren’t generally even considered. What we seek to do with our mutual fund positions is to look to broaden our holdings within asset classes and also mix asset classes appropriately to provide a certain level of diversification.

This doesn’t work very well in practice though, particularly among those who have a large exposure to the stock market and the market experiences a significant pullback. This is particularly the case with the strategy of looking to diversify one’s stock holdings. For instance, if you own an index fund tracking the S&P 500, all this diversification doesn’t help you when the index loses half its value, as does happen.

Managing Mutual Fund RiskIt is certainly true that there is additional risk in investing in a more narrow basket of stocks, such as those in a particular sector or a particular category, such as one that invests in new technologies, but diversifying one’s stock holdings merely turns a higher risk into one that is still very much exposed to bear markets.

In order to seek to address this somewhat, mutual fund advisors will recommend that a certain percentage of one’s mutual fund portfolio be held in income based assets such as bonds. If half of your portfolio is in bonds and half in stocks, and the stock market tanks, this will reduce the amount that your portfolio will decline, since bonds are more stable and do not decline like stocks do, even when they are both declining together.

During the Great Recession for instance, investors well diversified in bonds saw only a quarter or a third of their portfolio disappear versus the half that those more exposed to the stock market suffered.

Proponents of mutual funds will claim that none of this matters since the market has come back and actually is up a fair bit over the lows during that time, but risk is defined as the propensity for a holding to do down, regardless of where it ends up in the end.

This argument also assumes that there are only two alternatives, hold and sell, and ignores the strategy of selling during troubled times and re-entering during the recovery, although they have no good rebuttal for that one.

Many investors sold during this big decline and did not re-enter the market once things rebounded. Regardless, these declines in all cases represented risks and taking a long term view, regardless of the merits of such a view, involves ignoring these risks. We need to ask ourselves whether that is an appropriate strategy or whether an alternative approach may be better.

Why Risk Management Matters

The approach the industry sells us, the buy and hold approach that is, with the components of one’s portfolio being adjusted to manage risk, does look to manage risk somewhat, but in a fixed and passive manner.

In practice, investors tend to be too exposed to risk with this approach, and all we need to see is how people react to a bear market to have this made pretty clear. This isn’t limited to those who sold at the wrong time either, as any time people get upset about their positions, that’s exposing them to more risk than they are comfortable with.

When mutual funds are sold to investors, one of the requirements is to properly assess how much risk an investor is comfortable with. Typically, those who are comfortable and don’t get upset with a 20% drawdown are considered to be candidates for a large exposure to the stock market, even though we know that from time to time the stock market can decline by more than 20%.

If we took the actual performance of stocks and used that as a benchmark, for instance 50%, we would see people being diversified with other assets much more than we do. If one is comfortable with a 20% drawdown in this case, this would mean that we would allocate no more than 40% of one’s portfolio in stocks, and for those with a lower comfort level, this would be adjusted down.

While there is much more to managing risk properly than making sure investors can handle the drawdowns that can occur, the risk in other words, if we at least achieve this level of comfort, we wouldn’t be seeing people panic the way they can when their positions go against them excessively.

We also need to cast aside the view that a fixed view of asset allocation is the only way to manage risk, as one can manage risk in the stock market or with any investment by taking a more dynamic approach to it, in a similar way that traders do.

When one places a trade, with a shorter term view than investors take, the trader takes on a certain amount of risk in the trade, and it is not the maximum amount that many investors take, to hold on through whatever downturns may come.

If one is not comfortable with more than a 10% drawdown in their positions when investing, and one’s position declines to that level, one can simply exit their position, and only re-enter when circumstances warrant.

One can set whatever level of risk one likes with this approach, and there should be no cases where one’s risk tolerance becomes exceeded, as long as we stick to our plan in accordance with these tolerances.

Risk is Not So Subjective Though

If we assert that we are not comfortable losing more than 10% of the value of an investment in a trade, and all investments are essentially trades by the way, this does not mean that this is the ideal level of risk to take.

Risk management is an objective standard, not a subjective one, although it’s certainly important not to exceed subjective levels as this would cause investors psychological duress and cause them to make poor decisions.

We usually view the maximum amount of objective risk as unlimited, as a buy and hold strategy would require, as after all, the goal is to hold. From there, we apply subjective standards, such as the 20% drawdown that we’re told is the amount we need to be able to handle, and adjust accordingly.

We can’t really say we’re managing risk properly from an objective standpoint if we don’t have any objective risk management controls though, where the objective limit is unlimited, right down to losing one’s whole position provided one is comfortable with that.

Risk is only properly calculated by seeking to assess the probabilities of something moving against us. If we are crossing the street for instance, we look both ways to decide if it is safe to do so.

Managing one’s mutual fund portfolio properly is a lot like watching the traffic flow, and basing our decisions upon objective criteria, our best assessment of where things are headed.

How We May Manage Mutual Fund Risk Actively

All investments need to be assessed regularly, otherwise we’re not really managing either the performance or the risk, and not managing either at all actually. While investments involve longer term time frames, and one will not be assessing performance and risk on the short term manner that traders do, this still needs to be monitored.

While a trader may act upon short term trends, even those occurring minute to minute with the shortest term trades, it is only because the average length of these trades are so short. If you’re only looking to be in a trade for a few minutes, looking at longer time frames than this would not make sense.

If the goal of an investor is to look to average their holdings over several years, as is typical, one can still evaluate its performance over these longer time frames. It is actually easier to manage longer term time frames than shorter ones, because there are fewer trends to manage.

One can set up charts with weekly or even monthly bars, and monthly bars are probably ideal for long term traders as they filter out the insignificant moves of markets and present longer term trends in a way that is more easily discernible even with less experienced investors.

Learning To Manage Risk

There are a lot of approaches that can be used to analyze performance on charts, and some that can be pretty complex, but for the amateur investor, and all investors are amateur by the way because this means they don’t invest for a living, it’s best to keep things fairly simple.

In terms of risk management, we’re looking to measure when the longer term trend is moving against us, which is actually not that hard to spot. The goal here is not to sell at the tops and buy at the bottoms, as some people think, and this is the stuff of fantasy actually, the mission here is to get out when a downturn is underway and enough momentum has been created.

If we look at a monthly chart of the S&P 500 over the last 40 years, we can see a few very distinct trends. The market rose from the early 1980’s all the way up to 2000, with only a few rather minor pullbacks. The almost steady rise from 1995-2000, during the tech boom, had many people predicting a bubble, and the bubble burst in 2000, with the market dropping in value by half.

Three years later, things settled down, and we saw a 33% increase over the next few years, until the housing bubble came along. Once things started going the other way, it wasn’t hard to tell that we were in for another big ride down, to the tune of about a 60% pullback.

The index bottomed a year and a half later, and we’ve been going up ever since, with the index tripling from its 2009 lows. This cannot continue forever of course, and we need to be wary of the potential for another bear market should circumstances indicate,  The current bull market could continue for another decade, or we could give half of it back, and only time will tell how this all will play out.

Depending on how long of a time frame one seeks to invest in, one could choose shorter time frames, using a weekly chart for instance, but the principles involved in this are the same across all time frames, from monthly charts to 1 second charts.

With investing though, the idea here is to have your money in other investments during the worst of the pullbacks, during the worst of the risk, and this by itself can not only successfully limit the amount of pain one endures with one’s investments, it can also significantly improve your overall performance and your overall rate of return on your mutual funds.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

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