The year has started promisingly when it comes to global stock markets. In just the first few weeks, the FTSE and the American S&P 500 index have set new records. But two weeks ago, the indices began to correct and volatility returned to the stock markets.
Especially in the week from 5 to 9 February, trading activity became increasingly nervous, and some prices fell significantly. The bottom line was that the maximum drawdown, which is the maximum loss recorded by major stock indices such as the FTSE, the S&P 500, the Nikkei 225 and the MSCI World, is already between nine and twelve percent for this year. In the past week, however, prices have recovered to some extent. Scalable Capital’s portfolios were also affected by the stock market turmoil, as the equity allocation is currently comparatively high across all risk categories.
Corrections like these are not uncommon, especially during periods of a long-term positive trend. The S&P 500 has lost ten percent or more nine times since 1998. In seven cases, the correction was relatively mild; it stopped before it became a significant downturn, and prices started to go up again. This was the case during the stock market corrections in 2015 and early 2016. In both cases, the S&P 500 fell by 12 to 13 percent but the setbacks were short-lived: after about three months the index continued on its previous growth trajectory. Keep in mind that In 2017 alone, the index reached new record highs 62 times.
Major stock market corrections of more than 20 percent also termed bear markets, in contrast, only happened twice since 1998: during the dot-com crisis between 2000 and 2002 and during the 2008 global financial crisis. Our chart shows the S&P 500 and its corrections since 1998.
Some investors are wondering why the current stock market correction and sudden increase in volatility have not led to more pronounced allocation changes in our portfolios. Our algorithm strives for controlled risk management, but does not pursue a hedging or stop-loss strategy. It is not designed to react to every setback in the portfolios by restructuring them. That wouldn't make sense either. If we were to reduce our equity exposure abruptly in response to every short-term market move, it would be quite likely that our clients would miss out on the subsequent market recovery. Brief market corrections are often v-shaped. If investors were to sell quickly during those periods, they would end up systematically getting out and in too late, which would lead to poor performance.
In other words, you have to bear a certain degree of risk if you want to benefit from the long-term performance of capital markets. Our algorithm ensures that each of our clients is invested in accordance with their respective risk profile. It adjusts their portfolios if the projected level of risk differs from the risk allowance. If, for example, a sustained increase in the loss risks indicates that the allowance might be breached, the allocation of the corresponding portfolio is adjusted, taking the impact of diversification into account.
The question remains as to how the algorithm deals with specific types of price corrections. Frequently, but not always, significant setbacks are preceded by a series of smaller “tremors”. For example, this happened before the collapse of Lehman Brothers, an investment bank, in the crisis of 2008 (you might also want to read our blog article "How does dynamic risk management work?"). The following chart shows the S&P 500 as well as its volatility index VIX, which serves as a measure of the magnitude of price fluctuations.
It’s easy to see: Even long before the Lehman collapse, volatility on the markets rose sharply, even though many investors initially did not react to this increase. Such signs help our algorithm to cushion losses by reducing our higher-risk positions - even if the tremors do not last for months. On our page "Dynamic Risk Management” (bottom chart) we show for different risk categories how the weights of each ETF would have typically changed during this phase.
No equity reduction - price correction was not a significant change of the risk regime
So how did the algorithm deal with the current correction? The chart above provides some clues about this as well. It illustrates that the recent increase in volatility occurred very abruptly, i.e. without any previous tremors, and shot up quickly from an extremely low level. From here on in, there are basically two possible developments: Either the increase in volatility remains a short-term outlier and the US stock market is heading for a calmer waters. Or the recent shocks have been tremors in anticipation of further turbulence.
Recent developments do not (yet) indicate that risks will remain at a high level in the long term. At its peak in the week of 5 to 9 February, the VIX rose to 37.3 points. But last week, the volatility index fell below the 20-point mark again. This corresponds approximately to its historical mean. It is therefore not surprising that our algorithm does not regard the current turbulence as a long-term regime change (yet) but rather as a short-term correction. As a consequence, it has not made any major risk-reducing allocation changes in our portfolios, and the share of equities remains relatively high across all risk categories. In the high risk categories (VaR 20% to 25%), for example, around 80% is allocated to equities. On a long-term average, however, these risk categories have equity shares of 49 to 56 percent.
It is important to understand that our dynamic risk management is geared towards ensuring that price fluctuations stay in line with the risk allowance of each portfolio and towards achieving above-average risk-adjusted returns in the long term. It is not meant to react immediately to every fluctuation of volatility by making hectic trading decisions. This would not be professional risk management, but “noise-trading” - a nervous reaction to daily stock market noise. Such actionistic behaviour does not lead to solid long-term performance. Our algorithm instead waits to make significant allocation changes until the increase in volatility can be deemed as a sustained change of the risk regime. This also means that each new development is taken into account when assessing the situation - and the algorithm’s assessment can change if further volatility surges follow in the next few days or weeks.
Of course, no algorithm can perfectly predict the timing of the stock market collapses. There is no perfect “stock exchange oracle” - this would be the equivalent of a money-printing machine. But our algorithm estimates the probability that stock market turbulence will persist for longer - with the aim of deriving sound long-term investment decisions. These do not always correspond to the gut feeling of human investors. But, as numerous studies show, gut instincts do not lead to long-term success when investing in capital markets anyway. We use rules-based procedures for the management of our portfolios that make use the latest findings of financial market research. This approach eliminates the negative influence of emotions and offers better prospects for attractive risk-adjusted returns in the long run.
Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.
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