Beyond Bulls & Bears

Managing Risk in a Volatile Market

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 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 so-called Value-at-Risk models which they believe failed to properly account for rare, “black swan” events – 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 a portfolio manager’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 portfolio decisions that are made, you’ve got to have risk management at every step.”

Tollette takes this integrative risk management approach a step further, noting the benefits of incorporating these efforts directly into the design of investment products themselves:

“It’s a lot easier to build in risk consideration and diversification from the inception of a product 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 product design phase to really figure out the risk parameters and limits that we wanted for a product…As a result, we can be reasonably comfortable with the way that product’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 so called “tail risk” that’s so hard to predict. And investors should be aware of their comfort level with the risk posed by “black swans”. Although some investors shun investment products which they believe may be prone to such risk, Tollette focuses on understanding and assessing it:

“Tail risk …basically refers to instruments 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 — 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.”

Even as some investors eye the recent market volatility as a source of risk, Tollette suggests that there may be a silver lining in the upheaval for those who exercise a long-term view of markets:

“What we are seeing in the marketplace over the last few weeks are real considerations regarding what’s going on in Europe, sovereign debt and the growth levels that we should expect to see from developed countries… It’s the kind of environment where a patient and long-term investor may actually find real opportunities in the marketplace.”

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.”

To learn more about Franklin Templeton’s approach to risk management, click here to download The Art and Science of Risk Management or click here to download Managing 5 Hidden Risks.

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