2010 Lane Reports

Is an Ultra-conservative Asset Mix Really the Answer to a "Fat-Tailed" World?

The Lane Report, January 2010
Friday, January 1, 2010 9:00 am
by J. Brad Strom

 In response to recent market volatility culminating with 2008's stock market debacle, many of Wall Street's top financial services firms are re-thinking the foundational mathematics upon which their risk models are based. This shift comes from the recognition that some of our most basic assumptions regarding market behavior and risk may somehow be flawed. The question being asked is: do the use of standard deviation as the primary measure of risk and a tidy "bell-shaped" distribution for expected annual portfolio returns allow us to make the most reliable estimates of long-term portfolio performance - - or do they lead us to dramatically underestimate risk? Clark McKinley, of pension fund giant CALPERS (California Public Employees Retirement System), was recently quoted saying, "We got blindsided by some developments that weren't accounted for by the models we were using." For that reason, the fund is now considering adding an "extreme events" component to its risk models.

Historically, most risk models and financial planning software have used "normal" or ‘bell-shaped" return distributions in their cash flow simulations. Conventional views about return expectations assume that extreme events, such as those we experienced in 2008, are akin to 100-year floods, happening so infrequently that their occurrence has hardly been considered in these traditional mathematical models.

New models now being developed assume that stock market returns actually fall along a "fat-tailed" distribution of returns - - not the more traditional "bell-shaped" return distribution - - indicating a much greater likelihood that market returns in any given calendar year may come in dramatically below long-term historical averages (e.g., 2008). Because of the greater risk of catastrophic loss associated with these "fat-tailed" return assumptions, financial planners incorporating them into their Monte Carlo cash-flow simulations are now recommending much more conservative allocations to common stock, relying more heavily on various conservative classes of fixed-income securities, in their client portfolios. Their intent is to insure against what was once considered the remote or immaterial risk of a loss of such magnitude that the accumulated return of a lifetime could essentially be wiped out.

The long-standing view, propagated by investment professionals and academics alike, has been that investment risk decreases over long periods of time, warranting a more aggressive allocation to common stocks. However, these new theories suggest that a longer time horizon may actually present a greater risk of catastrophic loss akin to 2008's 100-year flood, are turning that view on its head.

With the pain of recent loss still fresh in our memories, it's no wonder that financial planners' immediate response to this new research has been to recommend much more conservative portfolios to their clients, with significantly higher allocations to high-grade fixed-income securities. The problem with this approach is the greatly reduced expected returns associated with such securities make it much more difficult for clients to attain retirement goals. People are being encouraged to dramatically reduce portfolio risk after experiencing stunning portfolio losses in the face of what seems to be developing into a surprisingly strong bull market cycle.

While we acknowledge the heightened risk of these "fat-tailed" occurrences, we see a more effective means of dealing with them that doesn't have the debilitating long-term effect on portfolio return one inevitably suffers with an ultra conservative asset mix. By utilizing a careful, actively managed option collar strategy the risk of experiencing an extreme portfolio event can be mitigated. Utilizing fairly deep, out-of-the-money put options, when combined with an active call writing strategy, provides protection against extreme downside risk without crippling portfolio return.

Thus, we can buy the portfolio a safety net of put options, exercisable at below current market prices, pay for them through the writing (selling) of call options on existing holdings at set, above-market prices, and effectively chop off the "fat-tails" of the expected return distribution. Obviously, the strategy needs to be carefully conceived and carefully implemented, but makes good sense for many of the separately managed accounts we advise.

For further information, please write ([email protected]) or call Marc J. Lane at (312) 372-5000 to learn more about the ways in which Marc J. Lane Investment Management, Inc., mitigates its clients' investment risks.


J. Brad Strom is a Senior Vice President and Portfolio Manager of Marc J. Lane Investment Management, Inc. Mr. Strom is a graduate of Illinois State University (B.S.) and DePaul University's Graduate School of Business (M.B.A.). Mr. Strom is a Chartered Financial Analyst (CFA).



The Law Offices of Marc J. Lane, A Professional Corporation
180 North La Salle Street
Chicago, Illinois 60601-2701
(312) 372-1040
Nationwide: (800) 372-1040
Facsimile (312) 346-1040
Email:
[email protected]

Websites: www.MarcJLane.com


Send this page to a friend

Copyright © 2010 The Law Offices of Marc J. Lane, A Professional Corporation.  All rights reserved.

Announcing Marc J. Lane's 35th Book:

The Mission-Driven Venture: Business Solutions to the World's Most Vexing Social Problems

More About The Book
Our monthly newsletter