Portfolio Risk Management In Uncertain Times
By David X Martin, Enrico Dallavecchia & Jason Plawner
In these uncertain times, portfolio managers need to have defensive, proactive, and dynamic strategies for managing risk. The goal is not just to preserve capital, but perhaps more importantly, to take advantage of opportunities that often appear during periods of market volatility and economic turbulence.
Risk management isn’t just some nerdy theory – it’s about making smart decisions with incomplete information. Uncertainty is what makes judgement and decision-making so critical. Lessons learned – the good, the bad, and the downright ugly – are often our most valuable assets.
Successful risk management involves three steps: assessment of the situation, defining rules of the game, and making the decision.
Step 1: Assessment of the Situation
First, you need to know where you stand. A clear-eyed, thorough assessment of your current risk position is necessary before you can set goals and develop strategies.
Clearly understanding your goals and objectives, and what risks are required to get you there. Risks will always provide a service or disservice in your pursuits. Some risks are worth taking while others are not.
The key lies in knowing when to change your field of vision, studying the details while also stepping back to see the big picture. The big picture is meaningless without the details that form it. No picture is ever 100% clear. Known risks may or may not be worth taking, while the scope of unknown risks can never be fully incorporated. Plan to size your risks appropriately.
Understand the limits of your own knowledge and always question the assumptions of others. Even the most expert analysis can have blind spots.
Step 2: Defining Rules of the Game
Begin by identifying the risks you are not willing to take under any circumstances. Once those options are off the table, you can evaluate the remaining ones. How much risk are you willing to accept to achieve your goals? What do you have to gain if you succeed and what might you have to give up?
Years ago, while at a previous company, we were engaged by a world-class investment company to help senior management make a “how high is too high” decision — how much loss they could tolerate in a given position. After much debate, we settled on a simple answer: “too high” was a loss they’d be embarrassed to read about on the front page of The Wall Street Journal.
Staying below that number gave them peace of mind.
The company’s head of quantitative analysis complained that these limits weren’t precise enough.
We replied, “Better to be approximately right than to be precisely wrong.” “Touché,” he nodded as everyone laughed. “You’ve got a point there.”
Once you define your personal rules of the game, your boundaries, informed by tolerance for risk, decision-making becomes far easier. In the process, you may discover that your appetite is higher than your tolerance. Not uncommon – it’s true for many people. If that’s the case for you, simply structure your boundaries accordingly.
You’re also likely to discover that your relative tolerance drops when uncertainty and anxiety spike. Understanding this enhances your ability to adjust boundaries, providing the flexibility you need to respond and adjust quickly whenever circumstances require.
Step 3: Making Your Decision
Understanding your stress points helps you make better decisions earlier, before pressure can mount. Then create realistic contingency plans to protect against the downside; the best decisions are made when you have real alternatives that can provide upside to offset some downside.
Remember what we said earlier: risk is the absence of complete information. There are trade-offs with each decision, and there’s no one-size-fits-all answer. A strong foundation grounded in the unique needs and preferences of the investment owner (particularly for family offices and smaller pension funds) is critical to achieving your investment goals, especially during periods of market stress.
When it comes time to act, even a well-understood risk can still feel daunting. That’s the nature of it. Making risk decisions is so uncomfortable, you can sometimes feel it in the pit of your stomach.
We have a therapist friend who tells all her clients, “There’s no place on the map called ‘Safe.’” Safety is relative and so is risk – in investing as in life.
But look at the bright side: the more you systematically consider what matters most, what information is missing, and what collective wisdom suggests, the safer you’ll feel and the less risk you’ll be taking because your decisions will be better.
Applying the Framework
Now, let’s apply the three steps of smart risk management to overseeing a portfolio …
Portfolio Analytics
Use analytics that support a holistic approach to construction that reflects the owner’s full investment ecosystem, including distinguishing factors and holdings.
Qualitative analysis: Rank risks based on subjective evaluation using tools like a probability-impact matrix. Recognize “hidden” concentrations such as country or regional overweight and identify shifts in correlations. Diversification benefits often diminish when all assets fall together.
Quantitative analysis: Assign numerical values to risk using methods like Value at Risk (VaR), stress testing, and scenario analyses to model potential losses. Focus on risk-adjusted returns and maintain active oversight of key risk factors.
Risk attribution models: Attribute performance changes to specific risk factors or asset exposures. Evaluate tactical deviations from long-term allocation targets and ensure they align with the stated risk budget.
Proactive Risk Assessment
Historical data can mislead when regimes shift. What you want is a forward-looking risk assessment approach that integrates current macro indicators, liquidity trends, and valuation metrics.
Stress testing: Simulate outcomes under a variety of severe but plausible scenarios, such as a major recession, geopolitical conflict, or inflation spike.
Scenario analysis: Evaluate how different outcomes might affect your portfolio. For example, if interest rates rise faster than expected, which holdings are most at risk?
Fat-tail risk analysis: Low-probability, high-impact events (i.e., systemic financial crises or pandemics) occur more often than models suggest. Expect the unexpected. Be sure to incorporate them into your portfolio planning and governance.
Dynamic Asset Allocation
When correlations between asset classes break down, a static asset allocation strategy, such as the traditional Balanced Portfolio 60/40 mix of stocks and bonds, may fail to protect capital. Adopt dynamic asset allocation, adjusting exposures as volatility, correlation, and liquidity regimes evolve to capitalize on current market opportunities or mitigate emerging risks in near real time.
Granular Diversification
Diversify beyond asset classes. This means spreading investments across other dimensions, like sectors, industries, regions, and investment styles, as well as considering private markets. It is also helpful to judge every investment by its contribution to the overall portfolio’s goals and risk profile, rather than its performance within a specific asset “bucket”.
Tactical adjustments: Periodically adjust asset class weights based on evolving market conditions, economic indicators, and valuation metrics. This can translate into temporarily increasing exposure to defensive assets when volatility rises. Large portfolios may even adopt a philosophy of continuous dynamic management aligned with total fund outcomes.
Alternative investments: Consider adding assets with low correlation to traditional markets. These can include:
Commodities like gold, which can act as a store of value and hedge against inflation.
Hedge funds and private equity, which may employ strategies designed to navigate specific market conditions or are uncorrelated with the market.
Defensive Positioning
During turbulent periods, preserving capital often takes precedence over chasing high returns.
Maintain cash reserves: Hold a higher-than-normal amount of cash or highly liquid assets. This provides a buffer against market declines and can be used for opportunistic buying at lower valuations.
Invest in high-quality assets: Focus on companies with strong balance sheets, stable earnings, and proven ability to withstand economic downturns.
Use hedging strategies: Sophisticated investors can use derivatives, such as options, to protect against potential downside risk.
Emotional Discipline
Market uncertainty often triggers emotional decisions, which can be detrimental to long-term returns.
Stick to your long-term plan: Avoid making panic-driven sales during market downturns; history shows that disciplined investors capture recovery upside.
Implement dollar-cost averaging: Invest a fixed amount of money systematically over time. This removes emotion by forcing you to buy more shares when prices are low and fewer when prices are high.
Seek independent oversight: Bring in qualified advisors to question assumptions, challenge bias, discern any blind spots, and prevent fear-based mistakes.
Conclusion
After a crisis, the only thing people will remember are the judgment calls you made and the results you achieved. No one gives you credit for good intentions — only outcomes. The most credible results emerge from a disciplined process, a strong defense that includes collective wisdom, and a powerful, laser-focused commitment to getting it right.
David X Martin
CEO & CIO
Arctium Capital Management
Enrico Dallavecchia
President & COO
Arctium Capital Management
Arctium Capital Management is an Outsourced CIO service provider specializing in hedge funds and alternative investments, with a core focus on uncorrelated alpha—a strategy designed to deliver returns independent of market swings. Our flagship Arctium Uncorrelated Alpha Fund seeks capital appreciation, particularly during market downturns, by generating returns with minimal correlation to equity and fixed income markets. Led by two former Chief Risk Officers of major financial institutions, our team brings deep expertise in markets and risk management.
Jason Plawner
Head of Investments
Old City Investment Partners
Old City Investment Partners has been instrumental to the emergence and growth of many best-in-class private equity/credit, real asset/estate and hedge funds. Since 2006, the Firm has placed $13 billion of capital for these sponsors and is known for its consistent sourcing of differentiated investments, longstanding investor relationships, and collaborative, thoughtful approach to capital formation. Old City supports three stakeholders: Niche asset managers and business ventures that it assists in raising capital, sophisticated institutions and family offices to which it brings specialized investments, and independent placement agents to whom it provides extensive support and cross-platform opportunities.
