A new way of thinking about risk

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The 2008 financial crisis left many investors reeling in the wake of profound losses to their portfolios. Investors have realized that recovering from a sharp decline in portfolio value can take time and will require significant market gains (see Figure 1). They have also become more focused on risk and volatility and are looking for strategies that can shield them from significant market declines in the future.

Most investors base their perception of risk on the fluctuating value of their monthly statements. For many, risk is really about, "how much can I lose in a short period of time?"

Behavioural economists have been expounding for years that people prefer avoiding losses to acquiring gains. But how can investors ultimately put risk into perspective and get off the sidelines?

Figure 1:
Recovering from a sharp decline in portfolio value can take time and will require a significant market gain to break even again

^{Source: AGF Investments Inc. Illustration is for example purposes only.}

A new way of thinking

Traditionally, investment managers are judged and rewarded on the degree they aim to outperform their benchmarks. Yet, in today's volatile markets, preserving value by reducing exposure in negative periods and participating in positive markets is becoming increasingly important to many investors.

Figure 2:
The importance of avoiding extreme losses over chasing extreme gains

^{Source: Morningstar Direct. Identified are the extreme weeks with a swing of 10% or more, based on the weekly returns of the S&P 500 sectors for the 21-year period from January 1992 to December 2012.}

There are a lot of terms in the investment world to describe investment approaches. A partial list would include Buy and Hold, Passive Investing (Indexing), Tactical Allocation and even Market Timing. One you may not have heard of before is Defensive Allocation.

Defensive Allocation represents a new philosophical category in much the same manner that Indexing represented a fresh way of thinking about investing apart from the traditional active management model. Defensive Allocation is built on the recognition of the asymmetrical nature of the market, where the severity of market losses and market gains are not equivalent, and generates its returns by systematically managing the portfolio to avoid the extreme negative market periods. The expected benefits include increased relative and risk-adjusted returns and meaningfully reduced volatility.

Recommitting to equity markets with confidence is going to need a new way of thinking. Losing less can be a winning strategy for the way forward.

To learn more, visit AGF.com/RethinkRisk

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share and/or unit value and reinvestment of all dividends and/or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed; their values change frequently and past performance may not be repeated.

First published in August 2013.