The core idea of the article is to see portfolio risk as a seamless continuous curve composed of 4 distinct regimes. These risk regimes are identified by the potential size of the losses a portfolio can incur. For example, one way to define these 4 risk regimes is (0% to -5%), (-5% to -15%), (-15% to -35%) and (-35% to above). If we approach our portfolio risk management this way then a logical next step is to adjust/use appropriate risk management strategies as the portfolio risk transitions from one regime to next regime.
For example, for smallest market fluctuations (i.e., 0% to -5%), one approach to manage portfolio risk is by doing dynamic balancing like volatility targeting i.e., regularly balance the asset (stocks, bonds, cash...) allocation in portfolio such that total portfolio volatility is within a predetermined target.
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| Four modes of risk management |
To protect portfolio against even deeper losses i.e., 3rd regime (say -15% to -35%), an effective approach is to explicitly hedge the tail risk via option-like strategies. That makes sense as basically by using option like strategies, one is out-sourcing the risk.
Also it makes sense to use in this regime and not in earlier regimes as portfolio incurs cost in implementing this approach. Note: The risk management strategies to handle earlier regimes also has costs like whipsaws/giving up on gains for additional diversification in regime-2 or jump costs when doing re-balancing in regime-1.
One challenge is losses don't really care about our regimes definition and can seamless move from one regime to another making all above approaches to manage risk useless. Another big challenge is future is unknown. The reason I found this article interesting is it provides a framework to consider portfolio risk and to craft ahead a plan on how one can go about managing the portfolio risk and surprises. Your thoughts?
Link: Four Modes of Practical Risk Management
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