Global Head of Quantitative Research, Asset Allocation and Investment Risk Management – Citi Investment Management
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Investors should not have a knee-jerk reaction to volatility’s comeback
Navigating financial markets can be thought of in terms of a sailing voyage. In recent years, the investment environment has been calm — like glassy seas — due in large part to unusual interventions and policies by central banks. In fact, 2017 was the least volatile year in US equity markets in the last decade.1 However, markets have most recently reverted to more normal levels of volatility — the choppy waters are back — which has been jarring to investors who have grown accustomed to such smooth sailing.
The proper response to this re-invigorated volatility should not be a knee-jerk move to liquidate investments and flee to cash. Our analysis shows this to be a losing long term strategy. 2 So what, then, is the Private Bank’s response to this environment? Of course, it is reasonable and necessary to focus on risk exposure while constructing portfolios and managing the wealth of our clients.
But in Modern Portfolio Theory (MPT), upon which many asset managers rely as a foundation for their investment philosophies, upside and downside movements are treated symmetrically — gains and losses of equal magnitude are simply variances from an expected return. However, our proprietary methodology, Adaptive Valuation Strategies (AVS), focuses on downside risk as the aversion to loss is stronger than the pleasure of gains.
Additionally, AVS goes even further by focusing on extreme downside financial market movements like those experienced in 1929, the 1970s, 2000/01 and 2008. This long data series is the keel of our specialized risk measure, Extreme Downside Risk (EDR), which is designed to consider worst case scenarios — the rogue wave — when correlations converge towards one and there are simultaneous heavy losses across certain asset classes. EDR calculates the worst potential loss that a particular allocation may suffer within a rolling 12-month period over ten years.3
Engineering a vessel capable of withstanding rough seas is prudent in order to plan for the unknown over the horizon. Likewise, portfolio construction and asset allocation should take possible volatility into account and be implemented well in advance of market dislocations. And sitting in cash will not get you to your goals either. A fully invested asset allocation using our AVS methodology could help keep you sailing towards your investment goals while also helping to weather the storms along the way.
1 Citi Private Bank, Global Asset Allocation team, Bloomberg.
2 Citi Private Bank, ‘Sail with Asset Allocation’, 2018: https://www.privatebank.citibank.com/home/fresh-insight/set-sail-with-asset-allocation.html
3 EDR does not estimate the maximum possible loss. Potential losses for a given asset allocation may exceed the value of the EDR.