Many investors view permanent loss as the biggest risk. What tips do you have to deal with that?

Marina Gross: One way of measuring and controlling this risk is by using Value at Risk techniques. These techniques are well known in institutional investment circles, but for a retail audience it is a relatively sophisticated concept. Value at Risk considers the likelihood of rare events that could negatively impact a portfolio. (Analysts call this “left tail risk.”) Once you know the value that is at risk, there are many different ways of dealing with it in the portfolio.

Franck Nicolas: There are a number of ways volatility can be managed so it doesn’t produce bad decision-making and lead to the worst-case scenario for investors – permanent capital loss. A technique known as risk parity is fashionable at the moment. This entails giving an equivalent risk budget to every asset class in the portfolio. This fits with our preference of allocating capital according to risk allocation techniques.

Are there other ways to reduce volatility?

Marina Gross: In many cases, attempts to diversify portfolios to reduce volatility are flawed. Diversifying your equity allocation by geography, size or sector – in other words, by investment style – does not necessarily lead to a less correlated portfolio. We believe in diversification by factors, such as equity risk, foreign currency risk, credit spread risk and interest rate risk.

Franck Nicolas: Diversification is important in creating durable portfolios, but it’s not sufficient in itself. We would typically use derivatives in portfolio construction, which are a more direct hedge.

Durable Portfolio Construction® does not guarantee a profit or protect against a loss.

Investing involves risk including the risk of loss. Investment risks exist with equity, fixed-income, and alternative investments. Sophisticated and aggressive investment techniques such as leverage, derivatives, and short-selling can magnify a gain or loss.

This article is for informational purposes only and should not be construed as investment advice. The analyses and opinions referenced herein represent the subjective views of Marina Gross and Franck Nicolas as of September 2012. They are subject to change at any time based on market and other conditions.