Asset Management Equities
April 08, 2012
A Scheme for Softening the Impact of Down Markets
How you weight portfolio assets is critical to the impact of down markets on returns. There exists a security-weighting scheme that would have reduced drawdown risk.
By Andrew Y. Chin
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. ....