How to manage volatility in a low return world
Responding to changing market conditions while keeping abreast of a strategy is a delicate balance. However, it’s an important skill to develop if you wish to successfully invest using a dynamic asset allocation approach. In this article, we discuss how market volatility is different to investment risk, and how you can manage your investments during market volatility while sustaining minimal long-term losses.
We all know that market volatility can affect investment performance over the short-term. However, to change your entire investment strategy in response to short-term market movements can have devastating effects on the generation of your long-term wealth. Successful investment strategies that use a dynamic asset allocation approach enable investors to retain a long-term vision while capitalising on the ‘ups and downs’ of short-term market movements.
Market volatility and risk are not always the same thing
There is no denying that market volatility can present a risk to achieving investment objectives. It is, therefore, important that this risk is mitigated effectively to achieve long-term success. To fully understand this, it’s important to understand the difference between volatility and risk:
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- Risk – the probability of not reaching the destination (failing to achieve the investment objective). Risks are often hidden in places where not many people are looking for them. The best place to look for risk is within the ‘crowd’. Crowded positions; crowded investment strategies or investment styles all entail a significant risk of failure.
- Volatility – an unexpected deviation in the path to a destination (the investment goal). Volatility is often triggered in response to a wider recognition of risks. That is, volatility is a backward-looking measure of risk.
In essence, volatility is like losing some pieces in a game of chess where the aim is to win the game. An investor’s ultimate goal should be greater exposure to the upside of a rising market than to the downside of a falling market.
There are various ways to manage volatility in a low return world. These include:
- Being concerned about the downside risk, while paying little attention to the upside potential and holding a large cash/defensive position at all times in the expectation of another GFC. This will be a low volatility strategy but most likely a low return strategy as well. Investors who take this approach often opt for a managed/capped or low volatility investment strategy – in other words, selling when volatility rises and buying when volatility falls. This approach can lead to lower volatility, but introduces a significant risk of falling short of return objectives. More often than not, the time to buy is when volatility is high and risk premium is elevated, not when volatility is low
- Relying on diversification based on historical correlations. The shortcomings of this strategy are:
- Relying on historical correlations is dangerous; and
- Given that each percentage fall requires a larger percentage gain to break even, (e.g. a 20% fall requires a 25% rebound to break even), without the scope to increase exposure on rebounds, recoveries can take a long time. The more volatile and steep market corrections are, the longer a full recovery will take.
- Our choice – dynamically and objectively assessing upside versus downside risk – this means cushioning the downside risk while benefiting from the upside. It entails objective analysis, a fine balance between conviction and flexibility, and paying more attention to risk than volatility. The ultimate aim is to be exposed more to the upside in a rising market than to the downside in a falling market.
Is market volatility likely to continue?
There are certain factors that suggest market volatility is likely to continue.
These factors include:
We have been of the view that the global equity bull market (particularly in the US) is likely to have reached its mature phase. However, a lack of broad-based overvaluation, few signs of global overheating, low recession risk and a gradual global economic recovery all point to a low likelihood of a global equity bear market, but increased likelihood of frequent volatility spikes.
When it comes to managing the ups and downs of the investment cycle, the key is to engage in active diversification through an objective-based investment process, while resisting external influence from other investors.
About the Author
Nader Naeimi, Head of Dynamic Asset Allocation, AMP Capital
Nader Naeimi is Head of Dynamic Asset Allocation and Portfolio Manager for the AMP Capital Dynamic Markets Fund. With over 19 years of experience in financial markets, including 15 years as part of AMP Capital’s Investment Strategy and Economics team, Nader’s responsibilities include analysis of key economic and market factors influencing global markets.
(original article sourced from AMP Capital here)