Mind the noise

Finweek English Edition - - INVESTMENT -

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.

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