Journal of Investment Strategies

Risk.net

Investing across periods with Mahalanobis distances

Edouard Sénéchal and Brian Singer

  • We propose a new measure of investment opportunities across time.
  • We show how it can be used to allocate risk across different investment periods.
  • Volatility in investment opportunities makes risk allocation across time critical for investors.

The market dislocations that followed the subprime crisis were an illustration of varying investment opportunities. Like credit cardholders who, having stretched their budgets during the years of economic expansion, found their credit suddenly maxed out, many investment managers fully utilized their risk budget during the years of low volatility preceding the 2008 crisis and maxed out on their risk budget during the crisis. The implication is that to appropriately use one’s risk budget over time, one needs to assess not only where to take risk but also when to take risk. We propose an analytical framework to measure investment opportunities and allocate risk across time based on the Mahalanobis distance. We apply this framework to a simple stock/ bond allocation strategy to illustrate the importance of allocating risk across time.