Demystifying Downside Risk

Both investment goals and risk tolerance are essential elements of establishing an investor’s optimal asset allocation. Investment goals are fairly self-explanatory, but what does risk really mean? 

In our view, risk is the possibility of permanent loss. This is different from market volatility – a security’s rapid change in price within a short period of time. Volatility will pass, and generally presents no major issues if an investor is able to stay the course instead of attempting to time the market. 

But a permanent loss cannot be undone. For instance, an otherwise-temporary dip is locked in when an investor panics and sells during a downswing, or the investment itself is unable to recover due to fundamental reasons. For investors of Enron or Lehman Brothers or Swiber (for an example closer to home), those were permanent losses from which there was no rebound. 

This concept underscores Syfe’s focus on investment risk management and our use of downside risk to optimise asset allocation and build the most optimal portfolio for our investors. 

In stock market parlance, downside risk is the financial risk associated with investment loss. In other words, it is the risk of your actual return being less than your expected return.

Identifying your risk appetite

The investment process at Syfe starts with understanding your risk profile through our risk assessment questionnaire. There are three facets we look at:

  • Risk Needed: The amount of risk necessary to achieve your investment goal
  • Risk Capacity: Your ability to take risk, based on your financial situation and lifestyle
  • Risk Tolerance: Your propensity to take risk, i.e. how comfortable you are with risk 

Once the assessment is complete, you will receive your “score” in the form of a percentage we call Downside Risk. Your score, for example 17% Downside Risk, is also what we use to label our different portfolios. 

We offer 11 different portfolios, each labeled by Downside Risk categories ranging from 5% to 25% Downside Risk and in increments of 2 percentage points. Rather than describe our portfolios with vague terms such as “conservative” or “aggressive”, we have chosen to use Downside Risk categories instead so investors know right from the start, the level of risk they are taking on.

How we measure risk 

Downside Risk

What sets us apart is the way in which we measure risk. Syfe uses a Downside Risk measure known as Median Tail Loss (MTL), modeled on a “look-forward” basis via an advanced form of non-parametric Monte Carlo simulation known as Filtered Historical Simulation (FHS). FHS generates the probability distribution of possible values that asset prices could take in the days ahead. Risk estimates are then directly derived from the tails of the distribution.

Why use MTL instead of Value-at-Risk (VaR)? While VaR is a risk measure commonly used in the financial industry, research has shown that VaR is unable to capture the tail risk of loss distribution. For instance, if the 95% one-year VaR is $1 million, it simply means we can be 95% confident that over the next year, the portfolio will not lose more than $1 million. But if we fall in the 5%, VaR does not tell us how much we could lose.

MTL tells us the potential loss and it is a more advanced and accurate measure of risk. Several other characteristics of MTL (which are beyond the scope of this article but explained further here) put it an advantage over VaR as well. 

Simply put, MTL at a given confidence level is equal to VaR at a higher confidence level; MTL at a 95% level is simply equal to VaR at a 97.5% level. In other words, in 39 out of every 40 years, a Syfe portfolio in a 15% Downside Risk category (at 95% MTL) will not lose more than 15% in a given year. 

Putting it together  

At Syfe, all investors invest in a personalised portfolio constructed based on their unique risk profile. Our proprietary Automated Risk-managed Investments (ARI) technology monitors all investor positions that are marked to market daily. 

Your portfolio is continually monitored for MTL to ensure that your portfolio risk is kept in line with the desired risk level you have selected. Using Monte-Carlo simulations, we assess your portfolio’s expected risk level and automatically adjusts its component weights to keep your portfolio risk in check. 

For instance, during periods where higher market volatility has been forecasted, ARI will adjust your portfolio allocation and reduce your exposure to higher-risk asset classes. This ensures your portfolio risk stays aligned to your desired risk level. Conversely, during periods of market calm, ARI will adjust your portfolio allocation to weight more heavily in higher-risk assets. Your overall portfolio risk is still kept in line with your desired risk exposure, but you are able to capture the market upside as well.