Capital Investment

Managing Return and Risk

By ITR Economics on February 8, 2022

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ITR Economics is the oldest, privately-held, continuously operating, economic research and consulting firm in the US.

The below article was provided by guest writer Clark Bellin, President of Bellwether Wealth.

One of the most common questions I get regarding investing using the Optimizer process is, "How much should be in the Optimizer A versus how much should be in the B?" The answer really depends on your risk appetite.

There are two sides to the investment performance coin: return and risk. Too many people seem to focus on return. It is not only the more exciting statistic to watch, but it is much easier to comprehend. Risk on the other hand, while just as important, is much more complicated to grasp, especially when the investor’s eyes continuously gravitate back towards the return side of the coin.

There are many statistics used to measure risk. However, before even looking at the statistics, an investor must distinguish between systematic risk and unsystematic risk.

Systematic risk is something that impacts the entire market or sector. Examples are:

  • Interest rate movement impacts the entire equity market
  • Access to minerals can impact the entire computer chip sector
  • An OPEC meeting impacts the entire oil sector

Unsystematic risk is risk that is company-specific. Examples of unsystematic risk are:

  • The FDA doesn’t approve a highly anticipated drug
  • The CEO of a company is fired by the board for reasons that are withheld from the public for some time (or permanently)
  • The company's earnings fall short of analysts’ expectations

In introductory investment classes, it is taught that unsystematic risk can be diversified away – in other words, buying stocks in more than one company spreads out the various unique risks of each company, so all your eggs aren’t in one basket.

If we only focus on returns, a portfolio that is highly concentrated in a few stocks in an upward bull market will typically outperform a broadly diversified portfolio during the same period. But when the rug gets pulled out from under the investors in this concentrated portfolio, as is what usually happens when a market's rising trend hits its high, their returns show it. It is during this time period that the investor’s sentiment changes from excitement to panic, practically overnight, and irrational actions are taken. Investors will quickly question the thoughts and process that were in place when they were originally picking the stocks.

The Optimizer A has systematic risk. It uses exchange traded funds to invest in the sectors ITR Economics has helped identify as having the highest probability of performing well during the economic environment that is approaching investors. If we look underneath the hood of the exchange traded funds, we will see there are 50 to 100 stocks in each to which we have allocated varying percentages of the portfolio. That could result in anywhere from about 200 to 500 stocks being used in the portfolio.

The Optimizer B has unsystematic risk. This process uses machine learning and artificial intelligence to help identify stocks within the sectors that the model suggests will perform well. With the Optimizer B, the entire portfolio may only have 45 to 100 stocks depending on the allocation. This portfolio is much more susceptible to company-specific risks, which can in turn can significantly impact the portfolio in both positive and negative ways.

In simple terms, the Optimizer A complements the Optimizer B and should mute the volatility in it over the long haul. Also, the two should correlate to each other, or move in a similar pattern. But in short time periods, their movements may not correlate, and an investor won’t see a relationship between the two processes.

How much of each process you should own depends on how you will react as the market goes through volatile times. Many investment firms advocate using a risk/return questionnaire. I think there is some validity to them, but taking one just once doesn’t give accurate results. The mood you’re in when you answer the questionnaire impacts your answers. If you’re in a good mood – you can handle more risk. If your mood is slightly sour – you can’t handle much risk.

If you were to rely ONLY on a risk/return questionnaire, I think you would need to answer the questions weekly or monthly and then take an average of the results to come up with a baseline risk/return profile. This is not practical.

A simpler approach involves conversations that reflect on past experiences. How did you react in past market pullbacks? If you didn’t sell during the pullbacks, how did you feel when you got your statements during the pullback periods? What is the forward-looking objective of the money? How do you define "long-term"? What defines long-term success for you at this stage of your life? What does the rest of your portfolio look like? In many cases, the Optimizer is our core equity process, but we do add other asset classes to help meet an investor's overall objective.

In the end, a mix is usually the right answer. It not only smooths out the volatility, but it also smooths out the investor’s reactions when the equity markets stop running hot.

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