Measuring and reducing the risk of loss is always a concern
of equity investors, but it has become virtually an obsession
for many since the 200809 market drop. The key to
reducing risk is appropriate diversification (investing in a
basket of stocks rather than a mere handful) and getting
position sizes right.
For the purpose of this article, well look at the
impact of various security-weighting schemes on the return of
one well-known and well-diversified basket of stocks, the
S&P 500, over the past 16 years. The relationships, we
find, have positive implications for actively managed as well
as indexed portfolios.
Like many capitalization-weighted indices, the S&P 500
tends to be dominated by the largest-cap stocks. Sometimes,
though, these stocks become the largest-cap because of
excessive increases in their valuations. As a result, investing
in these indices may lead to buying high and selling low: the
opposite of every investors goal.
To avoid this risk of cap-weighted schemes, some investors
have turned to equal-weighting their portfolios, but there are
risks associated with that strategy, too. Because smaller-cap
stocks tend to be hit harder in down markets and fare better in
rising markets, equal-weighted portfolios and indices tend to
be more volatile than their cap-weighted counterparts.
We looked for a portfolio-weighting approach that could
offer the best of both worlds, while mitigating downside risk
which most investors fear more than volatility.
Volatility (the standard deviation of returns) is
symmetrical: It captures upward and downward moves equally. But
most investors typically hate losing money more than they love
winning. That is, they care more about market drawdowns than
market rallies. In other words, investors want upside, but not
A variety of risk metrics focus on downside risk; for
example, the Sortino ratio measures the return achieved per
unit of downside price movement.
We used the Sortino ratio and other drawdown-sensitive risk
metrics as guides to create a capital-allocation scheme based
on expected tail loss, or ETL. A stocks ETL measures the
potential losses in the worst scenarios were likely to
see the rare and infamous black swans as well as
in down markets generally. In the ETL-weighted portfolio, we
size positions so that each stocks ETL contribution to
the overall portfolio losses would be exactly the same.
Our research results are encouraging; drawdowns for the
ETL-weighted portfolios were generally smaller than for the
other weighting schemes. In the display below we highlight the
two worst drawdowns during the 19962012 period that we
studied, as well as the average drawdown.