Abstract:
Traditional portfolio optimization models implicitly or explicitly specify placement of capital as rather irrevocably and fully at risk through investment horizon(s) or continuously. Under this constraint, asset class allocation typically serves as primary mode of diversification, pursuing risk moderation by seeking to reduce portfolio variance. But investors adopting this construct find Risk Management inevitably failing to encompass risk containment, to limit negative variance, leaving drawdown risk unbounded to fully 100% loss.
Here we turn to the little-discussed yet universally-held and most basic of assumptions in Finance – that asset prices tend to trend – and consider implications of constructs reframed in a consistent and corresponding manner. Most important among these is enabling of pursuit of risk containment which, through stop-loss protocols (i.e., loss-contingent exits), seeks to limit negative variance, to limit drawdown depth. Additionally, with risk containment centered on Exit protocols, pursuit of growth can proceed in relatively un-conflicted form via traditional modes of capital deployment and via now logically-enabled price and return trend-contingent alternatives.
Within a more broadly-applicable capital allocation framework we illustrate how pursuit of risk moderation, such as through traditional asset allocation regimes, is logically and operationally subordinated to the objectively more pressing and critical matter of risk containment.
