Mind the noise
Should we be battening down the hatches? We believe not. How significant is it that the initial, potentially dangerous, Cypriot bailout plan, was even considered? As usual, there is a lot of clamour in the markets, which should remind you once again to have a clear strategy in place and not be a victim of investment whiplash.
We are in a neutral environment (or regime) – in other words, a regime that is neither ultra-conservative nor overly aggressive. This insight is depicted in our proprietary regime indicator, which is of pivotal importance in our multi-asset investment process, not least because it assists us in eliminating much of the noise we’re constantly hearing from f inancial markets. ( Between 0.45 and 0.55, the environment is on average neutral; the closer it gets to 0.45 and below, the more conservative one’s portfolio construct should be, and the closer to 0.55, the more one’s portfolio’s risk budget can be opened.) Regime identification will help you to manage your biases and instilling discipline, with the result that you will not be whipped around like a rag doll.
In addition, regime identification contributes to asset allocation adjustments for two reasons. One, static asset allocation is outdated. Second, we have an inherent tendency to anchor (that is, having a particular starting point or asset allocation, and making only slight adjustments to this) and added to this, to exhibit status quo (to do nothing).
Returning to the f irst advantage, the existence of a buy-and-hold or even stati- cally rebalanced portfolio to weather all storms is and was shown to be highly unlikely. Many market participants came to this stark realisation during the 2007 financial crisis (the effects of which still linger today).
The strategy then and which is still prevalent now, was to employ a static asset allocation solution and to generate alpha via stock selection. The problem with this approach is that, in the absence of expensive derivative protection strategies (which frequently have to rolled over in one’s portfolio), there is no mechanism for the management of downside risk. If you understand the the regime you are in, your reference point (or anchor) already changes and will allow you to manage downside risk at low cost.
Determining which regime you are in and are expected to enter is the first part of the solution to mitigating the influence of f inancial market noise. The second very important component is to construct an appropriate asset allocation for each regime. Asset allocation is the most important determinant of the variation of the performance of one’s investment portfolio. (As an analogy, deciding whether to take the N1 or the N2 will have a significant impact on the time it takes to arrive at one’s destination. Detours from these, analogously stock selection, play a secondary role.) An optimal asset allocation within each regime is highly dependent on the distributional characteristics of the asset classes (in your investment universe) and the interactions between these.
Once you have determined an appropriate asset allocation for each regime, you will be able to manage the vagaries of the markets with increased confidence. So mind the noise so you have the best chance of achieving your desired risk and return objectives.