Identify Hidden Portfolio Risk with PRISM

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Investing

Guillaume Decerprit Ph.D. | August 13

Using StratiFi begins with PRISM, our proprietary tool to identify portfolio risk. By using PRISM, an advisor can gain a detailed understanding of the threat presented by four key sources of risk - volatility, correlation, concentrated stock risk, and tail-event risk.

PRISM is a turnkey experience that analyzes a client account, using data acquired through uploading a portfolio or linking to PRISM through a custodial platform. Once PRISM analyzes the holdings, it generates a report that quantifies the threat of four key types of risk on a client’s portfolio, as well as computing a composite risk score comprised of the four different individual scores. To simplify the understanding of the threat we use a ten point scale with 1 being no risk and 10 being very risky.

The specific focus areas for StratiFi’s risk analysis are key, as each type of risk aligns with a concrete action that an advisor can take to lower the threat. Therefore, by using PRISM, financial advisors come away with actionable investment insights that can have an immediate effect on a client’s portfolio.

Here’s a closer look at the four types of risk and how PRISM goes about calculating their respective impact on a portfolio:

Volatility:
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  • Volatility Risk Score: This score measures portfolio exposure to swings in volatility.
  • Why It Matters: Even short-term losses can have a lasting negative effect on investment outcomes. Quantifying the risk posed by exposure to volatility helps advisors understand how an increase in volatility can affect the value of a portfolio. By reducing the Volatility Risk Score, advisors can provide clients with more predictable investment outcomes while avoiding the painful mathematics of the asymmetry of losses.
  • How It’s Calculated: PRISM separates assets with a positive Beta to the VIX index (a global measure of the market’s volatility) from those with a negative Beta and extracts their ratio and magnitude.

Correlation:
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  • Correlation Risk Score: This score measures how correlated the holdings of a portfolio become during large stock market downturns.
  • Why It Matters: Despite the perception of safety from diversification, seemingly disparate asset classes can move in unison during declining markets leading to coordinated loss events. Quantifying the connection between assets in a portfolio helps advisors understand how susceptible a client’s portfolio can be to these coordinated loss events. By reducing the Correlation Risk Score, advisors can help create more robust portfolios that can weather a wider variety of market conditions.
  • How It’s Calculated: PRISM calculates rolling six-month cross-correlations within the portfolio and then examines correlations between a portfolio and major indicators of market regimes including Volatility (VIX), Bonds (BND), S&P 500 (SPY), Gold (GLD) and Real Estate (VNQ).

Tail Risk:
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  • Tail Risk Score: This score measures how vulnerable your portfolio would be in the event of a market shock.
  • Why It Matters: The truth is large market losses can and do occur. Quantifying the risk on a portfolio, if and when a tail event occurs, can help an advisor understand the true resilience of a portfolio under the most strenuous market conditions. By reducing the tail risk score, advisors can provide the reassurance that a portfolio has adequate protection should something catastrophic occur with the markets.
  • How It’s Calculated: PRISM simulates portfolio performance relative to a standard 60/40 portfolio during periods where the 60/40 portfolio lost 10% or more in two weeks. The score is a measurement of the relative performance of the portfolio to the 60/40 benchmark.

Concentrated Stock:
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  • Concentrated Stock Score: This score measures the vulnerability created by large individual equity positions that comprise 5-10% of a portfolio’s total holdings.
  • Why It Matters: Large concentrated stock positions can dramatically increase a portfolio’s idiosyncratic risk. Quantifying concentrated stock risk can help an advisor understand whether it is necessary, or not, to implement a specific risk mitigation strategy around a concentrated position. By reducing risk associated with concentrated stock positions, advisors can mitigate large losses in the stock’s value, allow the value to continue to appreciate, and avoid the potential complexity that comes from selling the position.
  • How It’s Calculated: To calculate the concentrated stock risk, PRISM analyzes the individual holdings and their relative concentrations, and calculates risk based on the total number of positions held and the size of those positions in comparison to the size of the portfolio.

After calculating the individual scores, PRISM then rolls the scores up into a composite score. PRISMs calculates this score by comparing the individual scores to an average, and weights the scores to ensure that a low risk score in one component doesn’t underweight risk that exists from another source.

It is our hope that PRISM will be a powerful tool to help advisors gain a deeper understanding of the risk facing their clients’ portfolios. However, knowing about risk is only part of the equation. We want advisors to use PRISM to take action, lower portfolio risk and create more positive investing experiences for their clients. Doing so could lead to greater penetration of their balance sheets, and ultimately to growth and stability of their advisor practice.

If you would like to use PRISM to help your advisory firm identify risks, schedule a demo of our platform to learn how.

To learn more about the truth behind asset correlations and volatility, click here for our complimentary eBook "The Five Myths that Put Portfolios at Risk: Revealing the truth and improving investment outcomes using options."