The Dynamics of Risk: Implications for Asset Allocation Strategies

Abstract

Investors should have a sharper focus on the time dimension of risk and correlation metrics for the largest asset classes of equity and debt. We explore the dynamics of risk for large cap US equities and 60/40 stock/bond allocations over the decades and show that risk has fluctuated significantly. This implies that investors who have set risk preferences need to adapt their asset allocation strategies to these variations in risk and correlation. We show that strategies that utilize downside protection with equity index put options, specifically buffer protection strategy indexes, exhibit similar levels of risk reduction as 60/40 balanced portfolio strategies but have more variable beta exposure. Going forward, investors can benefit from incorporating dynamic risk and correlation forecasts into their asset allocation process and looking beyond fixed income diversification for risk management. Downside protection and other risk modification strategies within the equity bucket can be effective tools to better align the portfolio risk with investor risk targets.