UNDERSTANDING AND OVERCOMING MARKET VOLATILITY

REALITY BEYOND IMPRESSIONS

The paradox of the current situation is that the equity and bond markets have performed well since the financial crisis broke. However, private investors have been dogged by anxiety in the intervening years and felt that the outlook for the financial markets was highly uncertain.

If we focus on the period immediately following the Second World War by studying the S&P index, we observe:

• An upward trajectory for volatility. Each of the last three decades has been successively more volatile than the previous one;
• Higher numbers of volatility spikes. Over the 2005-2015 period, we recorded almost as many stock market sessions with a daily volatility level higher than 4% as there were over the previous 60 years (47 versus 49).

More so than average volatility, investors are particularly sensitive to market volatility when the markets are bearish; this reveals that investor sentiment is asymmetric, with greater sensitivity when the markets fall.

So the increase in volatility is even more pronounced when we focus on the volatility of bearish sessions. Given investors’ psychological asymmetry, this further heightens the sense of uncertainty and the perceived level of risk.

THE ORIGINS OF INCREASED VOLATILITY

The increase in volatility seems to have been caused by the higher numbers of macroeconomic shocks affecting both the “real” economic sphere and the financial sphere.

The growth of the overall level of debt over the past few years is likely to have an amplifying effect on future volatility. This effect could prove particularly influential during future economic recessions, when the repayment capacity of the most fragile economic agents (states and companies) will be called into question.

In addition to these economic factors, there is a debate on the very structure of the financial markets and particularly on the underlying liquidity of the markets and the role of trading algorithms. But leaving these debates and controversies to one side, there is a tendency for liquidity to evaporate during periods of market stress, leading investors to speak of liquidity as an “optical illusion”. The consequence of this seems to be an increase in short, sharp bursts of volatility.

Lastly, there are also doubts regarding the consequences that may arise from regulatory constraints and the negative interest rates imposed on banks.

ACTION TAKEN TO COUNTER VOLATILITY

The fight against the causes of increased volatility is fairly disorganised at this stage. Countries are torn between their competing desires to stabilise their debt burdens and stimulate the economy. For the moment, central banks are trying to stabilise the financial markets through a massive injection of liquidity that makes hefty debt burdens more bearable in the short term but raises countless long-term questions. It therefore seems that the conditions for higher structural volatility over the coming months have been met.

NEW EXPECTATIONS, NEW SOLUTIONS TO DEVISE

The various crises and volatility spikes have ensured that risk management is at the heart of investors’ concerns. Management companies (in the broadest sense of the term) have offered numerous responses. We believe it is essential to review all of these possible approaches and isolate those that offer investors a firm foundation on which to base their volatility expectations.

Indeed, the more investors are able to assess and predict how their portfolios will fare in difficult market conditions, the more they are able to approach the situation calmly and adhere to their long-term financial strategy. This should enable them to achieve their objectives.

To this end, we recommend simple, intuitive investments solutions.Two approaches seem perfectly suitable:

The first approach seeks to set a maximum level of volatility, which may be defined as the threshold beyond which volatility is deemed to be intolerable.

In practice, once the maximum volatility level is reached, the portfolio’s overall exposure to financial assets is reduced and then gradually increased again so that volatility drops below the tolerance threshold.

This systematic approach cuts through the various behavioural biases that may influence decision-making and lead to irrational behaviour. It really comes into its own in a context of increasingly frequent volatility spikes.

Along with the growing number of volatility spikes, we have noted that the average duration of these spikes is increasing. It is therefore wise for investors to use such strategies to protect themselves against volatility spikes, since their duration and frequency are rising all the time.

Here again we note an increase in the number of volatility spikes: 42 between 1995 and 2015 compared with 28 between 1945 and 1995.

The second approach we favour seeks to generate an attractive source of regular income from various asset classes, against a backdrop of high volatility and historically low interest rates. The objective is to identify sources of income beyond "traditional" sources, while ensuring that the portfolio is as diverse as possible.

Increasing the weighting of income in investors’ total returns* enables the volatility of the portfolio to be reduced, thanks to a regular flow of income. Furthermore, as we highlighted for the previous approach, this method helps investors know what to expect. If the income component is solidly constructed, it becomes relatively predictable for investors and helps to reduce the risk associated with market developments.

The first essential step in this process is to select the investment strategy best suited to your objectives. Seeking support as you invest will enable you to apply this strategy effectively. Your manager's role is therefore essential in helping you to consider the emotional aspect of any investment and reduce impulsive decision making, which could distance you from your long-term objectives.