Beyond Bulls & Bears

Managing Risk in Volatile Markets

Amid the resurgence of significant market volatility, many investors wonder whether risk management techniques have evolved since September, 2008. The events which brought giants such as Lehman

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Brothers and AIG to their knees raised questions of whether a misunderstanding of risk and risk management practices was at least partially to blame. Some even pointed the finger at risk models which they believe failed to properly account for “black swan” events – rare, unexpected events which in hindsight would have been predictable, such as the mortgage meltdown. Wylie Tollette, Franklin Templeton’s SVP and Director of Performance Analysis and Investment Risk, says avoiding over-reliance on models is important to mitigating risk: “Models are just another tool in an investor’s arsenal. I think any management approach that’s solely dependent on one particular model or tool is always going to be vulnerable to the flaws and inconsistencies that exist in all models…Having a great risk model does not mean that you’ve really incorporated and integrated risk management into your practices. It needs to be supported at each step and really built up both from the top down, with support from the top of the organization, as well as from the bottom-up. For each of the investment decisions that are made, you’ve got to have risk management at every step.” Tollette takes this integrative risk management approach a step further: “It’s a lot easier to build in risk considerations and diversification from the inception of a investment vehicle during the design phase than it is to try to sort of bolt it on later… We’ve worked closely with portfolio, legal, and product management teams during the design phase to really figure out the risk parameters and limits that we wanted for an investment vehicle…As a result, we can be reasonably comfortable with the way that vehicle’s going to perform in a variety of market environments.” Still, Tollette acknowledges that because “black swan” events are so rare, they represent the tail end of a normal risk distribution curve – the least likely events, or “tail risk” that’s so hard to predict. Investors should be aware of their comfort level with the risk posed by “black swans”: “Tail risk …basically refers to investment vehicles that perform really badly in extreme markets, so we have sought to analyze those types of investments wherever they may exist in our portfolios and make sure that we are aware of it – and ensure that the risk is intended, compensated, and understood. It doesn’t mean we won’t make the particular investment, it just means we have to make sure that there’s full awareness of the risk parameters.” Understanding and being aware of risk, Tollette suggests, may be a good approach to navigating through turbulent markets. Until next time, Beyond Bulls & Bears leaves you with a quote from Sir John Templeton: “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.”