How to manage volatility in a low return world

The end of quantitative easing (QE) is likely to lead to lower returns but greater short-term volatility. Dynamic Asset Allocation (DAA) can allow investors a way to navigate that volatility but also stick to their broader investment strategy. In this article, we discuss how market volatility is different to investment risk, and how you can manage your investments during market volatility while sustaining minimal long-term losses.

We are now moving to a new macro and investment environment as central banks like the US Federal Reserve shift from quantitative easing (QE) to quantitative tightening (QT). The new QT era likely means two things for investors: lower returns and higher volatility.

The old QE not only provided a tailwind for returns but it supressed volatility. Every time bad news hit, the markets would go up because investors bet that Central Banks would respond to negative events and ease again. Those days are over, and investors must learn to manage volatility in a low-return world.

Volatility doesn’t just affect short-term performance. It can also cause investors to panic and abandon their entire investment strategy with potentially devastating effects on their long-term wealth.

The good news is that by using Dynamic Asset Allocation (DAA), a strategy that allows investors to regularly adjust their allocations to markets and asset classes based on what the market is doing and what it is likely to do, investors cannot only capitalise on short-term volatility, but also stick to their long-term investment plan amid market ups and downs.

But how do investors use DAA to manage volatility?

Understanding volatility

The first step is to understand what volatility is and how it is different from risk:

• Risk is the probability an investor won’t reach their destination – they will fail to achieve their investment objective. Risks are often hidden in places where not many people are looking. The best place to look for risk is within the ‘crowd’: Crowded positions and crowded investment strategies or investment styles all entail a significant risk of failure.
• Volatility, however, is an unexpected deviation in the path towards an investor’s destination (the investment goal). When markets recognise risk it often triggers volatility. Volatility is a backward-looking measure of risk. Volatility is like losing some pieces in a game of chess where the aim is to win the game. An investor’s ultimate goal should be greater exposure to the upside of a rising market than to the downside of a falling market.

The key is to not let volatility frighten you off course, but to use it to reach your investment goals.

How to manage volatility

The next step is to then understand how to manage volatility. We believe three principles will help investors successfully manage volatility in the low-return world that we are now entering.

1. Buy when volatility is high

The first principle is to remember that you can’t be concerned solely about the downside risk and ignore upside potential. Many investors always expect another global financial crisis and therefore hold large cash/defensive positions. Yes, this is a low-volatility strategy, but it will also be a low-return strategy as well.

Investors who take this approach often opt for a managed/capped or low-volatility investment strategy; in other words, they sell when volatility rises and buy when volatility falls. This approach can lead to lower volatility but introduces a significant risk of falling short of return objectives. Under this strategy, the time to buy is usually when volatility is high and risk premium is elevated, not when volatility is low.

2. Don’t use historical correlations to diversify

The second principle is don’t diversify your portfolio based on historical correlations. Relying on historical correlations is dangerous. Each percentage fall requires a larger percentage gain to break even, (e.g. a 20% fall requires a 25% rebound to break even), so if investors can’t increase exposure on rebounds, recoveries can take a long time. The more volatile and steep market corrections are, the longer a full recovery will take.

3. Dynamically assess upside versus downside risk

The final principle is that investors should dynamically and objectively assess upside versus downside risk. They should aim to cushion the downside risk while benefiting from the upside. That requires objective analysis, a fine balance between conviction and flexibility, and paying more attention to risk than volatility. The ultimate aim is for investors to be exposed more to the upside in a rising market than to the downside in a falling market.

A new era

There are a number of factors that suggest that in a new QT era returns will be lower, but investors will also have to deal with heightened volatility. We have been of the view, for example, that the global equity bull market (particularly in the US) is likely to have reached its mature phase.

This new environment requires a new game plan that allows investors to manage that volatility.

If investors can use active diversification within an objective-based investment process, they will have the flexibility to not only manage – and potentially profit from – the ups and downs of this new phase of the investment cycle, but also to stick with their long-term investment plans that will deliver their financial goals.