The payoff of forward looking risk management

by Olivier Le Marois & Raphael Douady, 2009

Investors and asset managers experienced a period of extreme market stress in 2008 – probably the highest level of market anxiety that most investment professionals working today have ever faced, or will ever face again.

While desiring to resume “business-as-usual” and not dwelling on what transpired is understandable, doing so will only lead to more distress in the future. Asset managers and investors simply cannot carry on as if another catastrophic event won’t happen again, because most likely it will re-occur.

The ability of long-term investors to survive the next market storm is directly linked to both their level of preparedness, and their capability to plan ahead for the next major upheaval. Successful realization of these objectives ultimately depends on using forward- rather than backward-looking risk management techniques when analyzing portfolio risk.

Forward-looking risk management enables analysts to answer questions such as:

  • How much could the portfolio potentially lose in the current market environment?
  • What are the most adverse market scenarios that may be envisioned? (Equity down or credit spread up etc.)
  • How would these scenarios impact the portfolio? (What if the S&P 500 falls 20%?)

If one could look forward and identify portfolio risks, what difference would this make? How would it impact results? What does the ability to look forward at risks add to overall performance?

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