Disciplined Investing: Diversifying for extreme events
Jul 26, 2010
In its first major eruption since 1823, the Icelandic volcano Eyjafjallajökull has recently become of particular interest to geologists and air travelers alike. From April 15th- 20th, the massive dispersion of volcanic ash caused the cancellation of most flights to, from, and within Europe, creating an unexpected disruption to commerce. The phenomenon also raises an important question for asset managers: how does one effectively hedge against these types of unique risks? Even if the manager could effectively prognosticate the probability of a volcanic eruption and was able to correctly anticipate ash dispersion patterns, could he still correctly predict the effects on each security in his portfolio?
Financial markets are subject to exogenous risks arising from outside the economic system (like wars and natural disasters) as well as endogenous risks that arise from within the system itself– e.g., banking crises. Both exogenous and endogenous risks can have a considerable impact on a portfolio’s returns. Nearly any event in the world can have some impact, however minute, on the value of a given investment. Regrettably, the probabilities of each risk and the magnitude of its effects cannot be consistently projected with accuracy by even the most sophisticated computer models. We consider how an investor should select assets for purchase given these considerable information constraints.
When it comes to investing, adhering to the maxim “don’t put all your eggs in one basket” is paramount. Each security responds somewhat differently to a change in macroeconomic variables like interest rates, currency exchange rates, commodity prices, and inflation. The most efficient means of managing these disparate risks is to construct a highly-diversified portfolio that can weather a variety of storms, both anticipated and unforeseen. That is, diversification is the single most effective mechanism for managing portfolio risk.
For example, rising oil prices generally weigh on the profits of airlines, who are heavy petroleum consumers. However, oil price changes generally have a much smaller impact on banking shares, whose profits are driven by different factors. Because their stock prices do not generally move in tandem, banking stocks are said to have a low correlation with airline shares. Accordingly, adding them to a portfolio of airline shares lowers the portfolio’s total volatility. By purchasing stocks of oil exploration companies, a segment of the portfolio would stand to benefit from a spike in energy prices, further offsetting any adverse performance effects from the airline shares. As the asset manager raises the level of industry diversification in this manner, the portfolio it becomes increasingly immunized to company- and industry-specific risks.
Just as adding stocks of diverse industries lowers the risk of a domestic equity portfolio, inclusion of additional asset classes (like real estate, bonds, and international equities) reduces portfolio volatility even further. Once again, the principle is the same: in a given economic environment, some assets tend to zig while others zag. For example, real estate and equities both tend to benefit from modest rises in consumer price inflation. In contrast, fixed-rate bonds benefit more from stable (or declining) consumer prices.
With sufficient diversification across asset classes, the investor gains considerable protection from most macro factor risks. Unfortunately, in periods of extreme systematic stress like terrorist attacks, natural disasters, and banking crises, even a well-diversified investor frequently suffers. Asset correlations which had previously been low (or negative) begin to rise dramatically– that is, the prices of risky assets decline in unison. Investment eggs, which had been thoughtfully allocated to numerous baskets, begin to simultaneously break.
During these periods of heightened uncertainty, the demand for cash and other liquid instruments increases dramatically. Rather than immediately spend their cash, businesses, banks, and consumers become highly reluctant to part with their money. Investors apply a much higher “liquidity premium” to stocks, bonds, and real estate, weighing on their prices. However, the bid for the safest, most liquid instruments also rises in these “flight-to-quality” scenarios.
When risky asset classes (like corporate bonds and real estate) begin their simultaneous downward move, U.S. Treasury bonds can provide an effective hedge against the fallout. By allocating a segment of their portfolio to long-term Treasury bonds, investors are essentially purchasing an insurance policy which helps to protect them against a sudden spike in correlations amongst other asset classes. When the systematic crisis strikes, the Treasury “insurance policy” pays out its “claim,” providing the investor with some “dry powder” to make a timely reallocation into riskier assets. Consider the relative performance of stocks, corporate bonds, and U.S. Treasury bonds during three crisis periods over the past fifteen years: the 1998 Russian debt default, the 2002 recession, and the 2008-2009 banking meltdown.
In each of the crises, equities were the worst-performing asset class by a large margin. Corporate bonds performed markedly better, benefiting from declines in long-term interest rates. However, the favorable interest rate effects were partially offset by a rise in credit and liquidity risk premiums. In contrast, Treasury bonds consistently produced superior returns, with longer maturity issues outperforming intermediate duration bonds.
Whether insuring your home, car, or portfolio, it is important to purchase your policy from a solid insurance company. As illustrated by the recent experience of Greece and Portugal, all government debt is not created equal. Political, fiscal, and monetary stability are absolute prerequisites in order for a sovereign issuer to pay out portfolio insurance claims in time of crisis. And despite heightened concerns over his currently elevated budget deficits, the “Uncle Sam Insurance Company” still meets those criteria.
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