How to Best Manage Risk in Today’s Market

03/19/2012 8:30 am EST

Focus: MARKETS

Jack Ablin

CIO & Executive Vice President, BMO Private Bank

The days of buy and forget are over, says Jack Ablin, who explains one important signal he follows to determine when the markets are too risky.

How should we be managing risk in a volatile market? We’re talking about that today with Jack Ablin. Jack, give us your view.

Well, thanks, Kate. I’ve enjoyed being here. I’m here talking about managing risk in a volatile marketplace. It’s a theme that I’ve been studying for quite a while.

In a market like this that started in roughly 2000 or 2001, what we find is that those long-held beliefs that we’ve sort of grown up with, like buy and hold…and you know if you hold long enough, things will work out, and diversification by having a lot of disparate asset classes that you’re able to lower your risk, we find have been called into question in this latest cycle. So really we find we have to make adjustments for both of those.

Well, as you’ve noted here, there has been a lot of correlation among asset classes. That’s something that much has been made of recently. How do investors work around that?

Sure. So really, what are the implications of that?

I think what we find is that an investor or a money manager who has used history to build their portfolio—so let’s say they’ve looked at the market between 1988 and 1998, put together a portfolio for a client that they thought would have a risk profile that would be equivalent to an environment like that, set up a 60/40 mix—that would be fine from 1998 to 2008, but that portfolio actually overstated that risk by something like 70% of the time.

In other words, if you’re using history to build a risk profile, you’re going to find you’re going to unwittingly have way more risk than you assume. So what we’re trying to do is monitor risk on an ongoing basis to see what kind of risk there is in the marketplace on a month-to-month basis, and make adjustments accordingly. So it’s certainly a much more arduous process.

Thankfully, we don’t think it will persist forever. But as long as we’re in this rollercoaster type of secular market, which I think will last until probably 2015, we have to be much more agile in managing risk on a dynamic basis.

So, given all of this, Jack, what should individual investors be doing in their portfolios?

I think this notion of buy and hold is great for institutions and for those who have 30-year time horizons. But I find most individuals don’t have a 30-year time horizon. They probably have closer to ten, or maybe a 12-year time horizon. So what they really need to do is monitor risk on a much more dynamic basis, be willing to actually take risk off of the table.

So we use, for example, one metric that we use is momentum. What we find is if the market breaks below its 200-day moving average… and we put an extra margin of 5%. If the market breaks below that, we’ll start taking risk off the table.

We won’t put risk back on the table until the market moves above its 200-day moving average, plus 5%. It’s one of the five metrics that we monitor on a monthly basis.

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