Evidence-Based Investing

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Nobel Prize Winning Model: You Can’t Predict Returns, but You Can Predict Risks.

In financial services, too much time and energy is spent trying to predict the future movements of asset prices. But countless empirical studies have shown it is impossible to do so. This is why stock picking and timing the market are hit and miss; they almost never achieve sustained investment success.

It is possible, however, to predict risk to a certain extent. Risk is not constant over time and can be seen to cluster, with changing phases characterised by high or low volatility. This means that if the markets exhibit high volatility, i.e. risk this week, there is a greater than 50% chance that the next week will again be volatile. A high market return this week, on the other hand, doesn't tell us anything reliable about next week's potential return. The following two charts illustrate the weak relationship between current and future returns and the strong relationship between current and future volatility.

This Week's Returns Show No Relationship to Next Week's

Correlation of weekly FTSE returns vs. following week
(1984-2015, based on daily closing prices)

Correlation of weekly FTSE returns vs. following week (1984-2015, based on daily closing prices)

This Week's Volatility Is Typically Similar to Next Week's

Correlation of weekly volatility of the FTSE vs. following week
(1984-2015, based on daily closing prices)

Correlation of weekly volatility of the FTSE vs. following week (1984-2015, based on daily closing prices)

The insight that volatility "clusters" into periods of above-average and below-average volatility was originally developed by Benoît Mandelbrot and Eugene Fama. However it was Robert Engle who helped to develop this theory into models that can be used for risk forecasting; an achievement for which he was awarded the 2003 Nobel Memorial Prize. Scalable Capital utilises this feature of financial markets to improve the probability of meeting the risk preferences of investors and achieve improved risk-return profiles.

Learn more about the impact on our portfolio optimisation and the performance of your investment.

"The essence of investment management is the management of risks, not the management of returns."

Benjamin Graham, investor and mentor of Warren Buffett.

Invest Like the Professionals: Access to Leading Risk Management Technology.

Specific risk information rather than vague marketing terms.

In the financial industry, risk is often described in vague terms such as; ‘moderate’, ‘conservative’ or ‘opportunity orientated’, instead of making concrete statements about loss possibilities. The problem is that whilst a moderate portfolio may indeed have a moderate risk profile in a normal market environment, during periods of turmoil, risk levels can multiply quickly. The risk term ‘moderate’ is therefore relative to the level of market risk.

At Scalable Capital, we consciously avoid these meaningless concepts, which do not give investors any specific information about their risk exposure. Instead we quantify the concrete loss level for all investors.

Value-at-Risk: A professional risk measure for your private portfolio.

Each risk category at Scalable Capital is assigned a specific loss level, which should not be exceeded with a probability of 95% on an annual basis. This measure is referred to as Value-at-Risk, and has been widely used by insurance companies, banks and regulators. A VaR of 12%, for example, means that in a given year, with a probability of 95%, a portfolio should not lose more than 12% of its value. In other words, on average, an annual loss of more than 12% should occur only once in 20 years.

Our clients therefore know from the beginning how high their actual loss level is – in actual percentage sizes, and not just in relation to the market in general.

Our Risk Categories Explained.

Our UK Co-Founders Adam French, Dr Ella Rabener and Simon Miller explain how Scalable Capital uses percentages to label its portfolios and how this gives clients an unprecedented level of transparency about their investment risk.

Learn more about how Scalable Capital combines decades of scientific research with the latest technological innovations to offer dynamic risk management for your portfolio.

Read more about the foundation of our investment model in our Whitepaper.

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