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.

Managing volatility

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:

• • Global equity valuations (ex US) remain cheap however, the current weakness in US equities is taking place at a time when absolute valuations are rich, earnings growth is slowing and inflation expectations are falling. The valuation ceiling on US shares is likely to exert ongoing volatility to other markets.

• Ongoing dynamics relating to US rate hike expectations, the rising USD, falling EM currencies and tightening financial conditions should lead to ongoing volatility, as investor expectations with regard to the US Fed’s rate lift-off wax and wane.

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.

Nader Naeimi, Head of Dynamic Asset Allocation, AMP Capital