Legg Mason Global Asset Management
June 20, 2019
A leading global investment company with specialized expertise in equities, fixed income, and alternatives.

5 Principles for Smarter Portfolio Construction - #3 Recognize the Asymmetry of Volatility

Recognize the Asymmetry of Volatility 

It’s axiomatic that you must take on risk to access the return potential of the market. But how much? Academics would say that people are mean-variance efficient, i.e. they operate on a utility function basis; we want this much return and we’re willing to trade off this much risk. Our view: We recognize that in real life investors do this in an asymmetrical way; they’re much more averse to downside than upside risk in their portfolio. It’s rare to get an angry call from a client saying their portfolio has gained too much. Classic volatility analysis doesn’t necessarily account for this. That’s why, in our models, rather than seek to minimize total risk, we aim to minimize downside risk — or more specifically, a shortfall against a predefined benchmark chosen for our client’s objectives. This allows us to embed the concept of loss aversion in the pursuit of achieving the client’s objective.

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