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Quantifying your portfolio's risks

Guillaume Decerprit | February 13

Risk is fascinating. It hatches from pure randomness and lives with no clear intentions. The only thing you can do to begin to manage risk is to quantify it...but that is often easier said than done! Risk typically arises from various and intertwined sources, it can be hard to identify the right cause, and therefore difficult to identify the right solution to reduce your portfolio’s overall risk.

At StratiFi, we identified four main sources of risk and unique ways to mitigate them:

Risk of Correlation

Correlation is a key, but often misunderstood, indicator of effective portfolio diversification. In periods of downward market movements, one will often experience a sharp increase in correlation which often manifests as a large, coordinated portfolio loss event. This phenomenon highlights one of the chief limitations of traditional multi-asset class diversification and the economic cost to clients who have an incomplete understanding of total portfolio risk. At StratiFi, we specifically designed a proprietary Correlation Risk Score to quantify this very risk. We first look at rolling six-month cross-correlations within the portfolio. We then examine correlations between a portfolio and major indicators of market regimes including Volatility Index (VIX), Bonds (BND), S&P 500 (SPY), Gold (GLD) and Real Estate (VNQ). The resulting score, scaled from 1 (lowest risk) to 10 (highest risk) becomes a highly effective numerical indicator of the true diversification of your portfolio!
Extracted from StratiFi's PRISM tool for a typical 60/40 Portfolio during financial crisis.

Asset correlations in a period of crisis (2008-2009). Correlations of a typical portfolio with global market indicators become quite significant, especially with the VIX (Volatility) indicator.

Risk of Volatility

Volatility is inherent to any random process, and financial markets are no exception. Since we can’t just go and ignore it, the best we can do is quantify and alleviate its effects. At StratiFi, we have a proprietary approach to clearly and accurately quantify portfolio volatility. We separate assets with a positive Beta to the VIX index (a global measure of the market’s volatility) from those with a negative Beta and extract their ratio and magnitude. Volatility is perhaps the most direct indicator of systemic risk in the markets and is closely related to correlation, as large volatility swings are often the result of high correlations. Our StratiFi Volatility Score not only gives you a quantified idea of your systematic risk, it also gives the key to decreasing the risk as well. For example, a portfolio being 95% short volatility (that is, it loses money when volatility spikes) and only 5% long volatility (that is, it makes money when volatility spikes) can mitigate this risk by choosing to increase its allocation in “long-volatility” assets.
Example of volatility diversification for a hypothetical portfolio.

Risk of a Tail event

Though uncommon, as their name would suggest, left tail events do occur and can be reasonably expected to occur more often as our global markets, regulatory frameworks and geopolitical influences become increasingly complex . At StratiFi, we believe the problem plaguing most allocators is that they underestimate the frequency and magnitude of capital destruction that can accompany tail events. Further, their first line of defense against tail events continues to be traditional multi-asset class diversification. Tail events are inevitable and demand focused attention from all fiduciaries as they contemplate the stressed risks in their allocations. Everyone remembers the impact of market selloffs in 2000 (Dot-Com bubble), 2008 (Financial crisis), and even August 2015 (China currency float). We constructed our Tail Risk score to glean insights into how a portfolio may react to events such as these. Scaled from 1 (best) to 10 (worst), it will inform you how your portfolio might survive these rare, but regular events. Addressing this risk is crucial because a 33% move down in a few weeks necessitates a subsequent 50% move up to recover -- which can take years! Lastly, consider for a moment that the next catalyst for a historically notable tail event could be a huge spike up in interest rates, thus causing massive losses in both global equity and fixed income holdings. Will your client value proposition withstand such losses and the scrutiny to follow?

Empower your asset allocation by incorporating a StratiFi solution which addresses this quantified risk. StratiFi offers option-based overlays that are designed to protect against dramatic stock market selloffs.

Risk of Concentrated Positions

The risk of having concentrated stock positions is fairly well known, and of similar importance. The StratiFi Concentrated Risk score precisely quantifies this risk. We, at StratiFi, can help you work on your portfolio structure to keep this Concentrated Risk Score low.

By combining these four scores, we crafted an easy-to-read “overall risk score” uniquely designed to provide you with an intuitive indicator of your portfolio’s health!

Overview of our Portfolio RISk Management (PRISM) tool, identifying 4 key sources of Risk.

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."