Portfolio Construction in an Era of Uncertainty

The traditional rules of portfolio construction—diversify across asset classes, rebalance periodically, assume correlations remain stable—have been challenged repeatedly over the past fifteen years. From the Global Financial Crisis through COVID, from quantitative easing to rapid rate hikes, investors have learned that "normal" market behavior is less normal than textbooks suggest.

At Swan Risk Management, we've spent fifteen years helping investors navigate this uncertainty. Here's what we've learned about building portfolios that survive—and thrive—when conventional assumptions fail.

The Problem with Traditional Diversification

Modern Portfolio Theory promised that diversification would reduce risk. Hold uncorrelated assets, and when some zig, others will zag, smoothing returns over time. The math is elegant. The reality is messier.

The core problem: correlations aren't stable. They rise precisely when you need diversification most—during market stress. Assets that appeared uncorrelated during calm periods suddenly move together when fear takes hold. This isn't a bug in the data; it's a fundamental feature of how markets work under stress.

We saw this dramatically in 2008, when nearly every asset class fell together. We saw it again in March 2020. And we've seen it repeatedly in smaller episodes that didn't make headlines but punished investors who relied on historical correlations.

Rethinking Portfolio Resilience

If correlation-based diversification is unreliable in crises, what works? Our approach focuses on several principles:

1. Prepare for Tail Events Explicitly

Standard portfolio optimization focuses on expected returns and volatility—the center of the distribution. But the events that truly damage portfolios live in the tails. We advocate explicit allocation of capital to strategies and instruments designed to perform in extreme scenarios.

This isn't about being bearish or maintaining constant hedges. It's about having pre-planned responses to scenarios that, while improbable, would be devastating if they occurred. The cost of this protection should be viewed as insurance, not as a drag on returns.

2. Stress Test Against Scenarios, Not Just History

Historical stress tests are valuable but limited—they only capture events that actually happened. The 2008 financial crisis was "unprecedented" until it happened. COVID-19 was unimaginable until it wasn't.

Effective portfolio construction requires imagining scenarios beyond historical experience. What happens if Treasury markets seize? What if inflation reaches levels not seen since the 1970s? What if a major trading partner imposes capital controls? These scenarios may be unlikely, but portfolios should be evaluated against them.

3. Understand Your True Exposures

Many portfolios appear diversified on the surface but have concentrated exposures underneath. A portfolio with stocks, corporate bonds, and real estate might look diversified across asset classes—but all three share exposure to economic growth and credit conditions.

We encourage investors to look past asset class labels and identify underlying factor exposures: growth sensitivity, interest rate sensitivity, credit spread sensitivity, liquidity sensitivity, and so on. True diversification happens at the factor level, not the asset class level.

4. Build in Optionality

Uncertainty creates opportunities for those positioned to act. Portfolios should maintain sufficient liquidity and flexibility to capitalize on dislocations rather than being forced to sell at the worst moments.

This means accepting lower returns in normal times in exchange for the ability to deploy capital when others are panicking. It means maintaining cash reserves that might seem inefficient during bull markets. It means structuring positions to avoid forced selling.

5. Accept That Some Risk Can't Be Diversified

Certain risks are systemic—they affect everything simultaneously. No amount of diversification eliminates exposure to a global pandemic, a major war, or a fundamental breakdown in financial infrastructure.

Acknowledging this reality doesn't mean accepting helplessness. It means sizing positions appropriately, maintaining reserves, and having explicit plans for navigating systemic events. It means accepting that perfect protection is impossible and focusing on resilience over optimization.

Practical Implementation

Translating these principles into actual portfolios requires discipline and continuous attention:

• Regular scenario analysis: Not just historical stress tests, but forward-looking scenarios tailored to current market conditions and geopolitical realities.
• Dynamic hedging: Protection strategies that adapt to changing market conditions rather than static allocations that decay or become expensive over time.
• Liquidity buffers: Explicit reserves maintained for opportunistic deployment, with predefined triggers and deployment plans.
• Position sizing discipline: No single position or correlated group of positions large enough to cause permanent impairment if it goes to zero.
• Ongoing monitoring: Continuous surveillance of portfolio risk metrics with predefined thresholds that trigger review or action.

The Role of Professional Risk Management

Many sophisticated investors have the resources to implement these principles themselves. But few have the specialized expertise or dedicated attention that effective risk management requires. Managing risk is not a part-time job.

This is where professional risk management adds value—not by promising to eliminate risk (impossible) or by imposing rigid constraints (counterproductive), but by providing the analytical frameworks, continuous monitoring, and independent perspective that help investors navigate uncertainty systematically.

At Swan Risk Management, this has been our focus for fifteen years. We've learned through multiple market cycles what works and what doesn't. We've refined our approaches through the crucible of real-world stress. And we've helped investors sleep better knowing their portfolios are built for resilience, not just optimization.

Uncertainty isn't going away. If anything, the pace of change—technological, geopolitical, climatic—is accelerating. Portfolios built for a stable world will disappoint. Those built for uncertainty will endure.