The healing power of dynamic risk management

I’ve been dealing with knee problems for several years now. As a result, I started reviewing medical literature looking for options. During my research, I read a blog post by Dr. Kevin Stone of the San Francisco–based Stone Clinic. The clinic is considered one of the leading knee clinics in the county. It is the first stop for many pro athletes dealing with knee injuries.

Dr. Stone pointed out that the days of advising patients to “go home and rest in bed” to heal everything from a cold to an injured knee are largely a thing of the past. Much as we have found in managing client accounts, Dr. Stone has learned through years of practice that passively managing one’s recovery is outdated and largely ineffective.

He gave the following example:

When?a football player’s knee joint?is?hit from the side,?the medial collateral ligament?can?rupture.?In the past,?the knee was?placed into a cast or a fixed splint?and?the ligament healed over a six-week time frame. But?the?physical properties?and?strength of the?healed?ligament were weak,?leaving?it—and the?player—vulnerable?to a repeat injury.

We have since learned that?if motion is applied early in the healing process,?the ligament heals with a more normal appearance.

The harmful effects of a passive approach to recovery

In the financial arena, we have learned that a passive buy-and-hold managed portfolio can seem acceptable during a recovery with periodic rebalancing. However, most investors have learned to their sorrow that it is not effective in preparing one’s investments for a return to the normal ups and downs of the complete market cycle.

Not only does the resulting loss of dollars hurt the pocketbook but it permanently scars investors. They become fearful of investing in the next market cycle, being slow to return to investing in stocks. This is injurious to their long-term financial health, which is dependent on the appropriate use of equity investments.

Dr. Stone also addressed the issue of scarring. He pointed out that scar tissue is not only ugly but that it is detrimental to healing:

At first, the?eruption of the?tissue?repair process creates a tangled mess of collagen fibers.?While normal tissues are made of a mixture of small and large collagen fibers, this new tissue contains only?small-diameter fibers?and has the biomechanical and structural properties of scar tissue.?Over time,?the body can either remodel this scar?tissue?into normal tissue?(as it does with bone)?or?form?the familiar?scar tissue?we often see?with?healed?skin.?

To prevent this, medical research has found that adding activity early in the recovery process is essential. Without activity, scar tissue results rather than truly healed tissue.

Notice in the quote from Dr. Stone at the beginning of this article that his findings relate to activity in the early stages of the healing process. It is not enough to add it later in the process.

The “healing” effects of an active approach to recovery

In finance, we know the need for early action. That’s why most of our clients have gone to professional financial advisers for advice on their portfolios long before, or early in, retirement.

Their financial advisers, in turn, know the value of creating a financial plan. They prepare portfolios that can take advantage of the recovery process from financial crises.

These astute advisers also know that you must have a plan for when the recovery ends or the unpredictable happens. They’ve learned that such events can leave their clients vulnerable to portfolio losses.

In medicine, Dr. Stone recommends activity to prevent further injury. But what kind of activity?

The motion has to be enough to provide stress,?but?not so much that it disrupts the healing fibers.?This?motion stimulates the repair cells to produce fibers?that are?oriented?along the lines of stress.?The?motion-aligned fibers?also?have a more normal distribution of large and small diameters,?rather than?the tangled variety of fibers?formed?when the knee is placed in a cast.

Similarly, the activity used to prepare a portfolio for a black-swan crisis is not just any kind of motion. Activity generated by investors acting on their own can be injurious. In a contradictory manner, they can procrastinate and act too quickly. They respond to emotion and news events.

The activity spurred by these actions has proven harmful. Recent yearly studies demonstrate this. Investors managing their own accounts fall substantially behind even the passive indexes.

As Dr. Stone concludes: “But how?do you know?exactly?how much motion is enough?and not too much? As physicians?and physical therapists,?we make educated guesses.?We know impact exercises are often too much, and cycling is often just right.”

In our case, we use proprietary research spanning decades to create strategies and portfolios that are responsive to past market environments, including major financial crises. In fact, we’ve created a Crash Test report for portfolios of our strategies to illustrate this (you must be a financial professional logged in to our website to access the tool). “Crash testing” a portfolio or strategy produces a Durability Score. The closer the score is to 30 (the number of conditions the tool tests against), the more likely a strategy or portfolio is to profitably manage through those conditions.

Just as medicine seeks to use activity to speed recovery, all of our investment strategies use an active approach. Our strategies are designed to use activity to provide another layer of risk management that passive portfolios cannot deliver. In addition, combining these strategies or adding them to a passive portfolio can result in diversification that exceeds the preventative care attainable by a portfolio diversified only by asset classes.

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As the doctor says, passive treatment in recovery is outmoded, just as dynamic risk management and strategic diversification are today’s prescription of choice to prepare for and heal from unpredictable times.