Dancing with risk
Investor behavior data reveals some insights into how investors are answering big questions pertaining to their financial life. This data suggests that many investors dance between a state of risk-seeking and risk-avoidance in their allocations; “I want to take part – but, no – I’m afraid.” In other words, clients want participation in markets, but also want protection from severe drawdowns. The end result is a kind of hectic investment strategy speed dating. Yet the chart below points to how an investor’s ability to stay invested may have more effect on portfolio performance that what assets an investor holds.
Investor returns in equity funds, asset allocation funds, and fixed income funds underperformed the S&P 500® Index1 and the Barclays Aggregate Bond Index2 over the 20-year time period ending December 31, 2017 – as well as the 10-year, 5-year, 3-year, and 12-month time periods. This indicates that, instead of seeing a lot of strategies, investors who are spending all their time trying to select the best asset allocation mix may be better served by just staying invested.
Source: “Quantitative Analysis of Investor Behavior.” 2018 QAIB Report. Dalbar.
Performance clusters: alone together
One way for financial professionals to help keep investors invested is to make sure the investment doesn’t have performance characteristics that are too out of line with the investor’s risk tolerance. To help enact this approach, let’s plot the monthly returns of the Dow Jones Industrial Average (DJIA)3 from 1900 to December 2018. If a hypothetical investor – let’s call her Jane Smith – has a pain threshold of not losing more than 10% in one month, she would likely want to avoid monthly performance that could include losses of -10% or greater (demonstrated by the purple bars in the bar graph below).
Source: Bloomberg Barclays
Put simply, if Ms. Smith can achieve monthly returns that are greater than -10%, she will be more likely to stay invested. However, the truth is that large negative monthly returns are often clustered around periods where there are large positive monthly returns. This performance clustering is apparent when the time period 1900 to December 2018 is viewed sequentially. In the graph below, the arrows indicate notable parallel occurrences of negative and positive DJIA performance.
Performance clustering suggests that in order for Ms. Smith to avoid large losses, she may also have to sacrifice potentially large monthly gains. The end result would likely be a performance profile that is less turbulent, or similar to the mean.
Accounting for volatility
Historical evidence also suggests that periods with the highest volatility coincide with periods of lowest returns. The table below showcases how different volatility regimes correspond to periods of under- or overperformance. Thus, there appears to be a close relationship between high volatility levels and negative performance in market returns. Conversely, periods of low volatility seem to correlate with positive performance.
Using this logic, an investment that is scaled to volatility – decreasing market exposure when volatility rises and increasing exposure as volatility falls – could help Ms. Smith stay invested over the long term. Scaling equity exposures in line with volatility could provide her with increased participation in up markets (when volatility is low) and more protection in falling markets (when volatility is high).
Working to provide the median of returns instead of their extreme may help solve for the commitment issues of some investors. Instead of moving in and out of many different strategies, this kind of strategy could help them get onboard for the long term and remain committed. A modulated exposure to equity markets that accounts for volatility has the potential to provide Ms. Smith with a healthier, more enduring relationship with her portfolio. After all, she is more likely to find happiness in a portfolio that provides support and encouragement in both the bad times and the good.
2 The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the US-dollar-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, government-related, corporate, mortgage-backed securities, asset-backed securities, and collateralized mortgage-backed securities sectors.
3 Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.
Drawdown: a peak-to-trough decline during a specific period for an investment, trading account, or fund. A drawdown is usually quoted as the percentage between the peak and the subsequent trough.
The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the US stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPXSM) call and put options. On a global basis, it is one of the most recognized measures of volatility -- widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.
The term volatility regime refers to period in which financial markets rise or fall more than one percent over a sustained period of time.
Volatility management techniques may result in periods of loss and underperformance, may limit the Fund's ability to participate in rising markets and may increase transaction costs.
CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.
Diversification does not guarantee a profit or protect against a loss.
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.