China’s attempts to shore up its domestic growth through currency devaluations and aggressive monetary stimulus have unnerved many investors around the globe. As a result of this and other macroeconomic events like the drop in oil prices and the uncertainty surrounding rate lift-off in the US, equity markets have sold off sharply and volatility has spiked. On Aug. 17, the CBOE Volatility Index (VIX) was around 13; just one week later, however, it had jumped to nearly 411 – a level last seen in October 2011 during the eurozone sovereign debt crisis.
These extreme short-term gyrations can be quite stressful, but are an excellent time to reflect, not react. The investing horizon for most investors is measured in years, if not decades — not days. Therefore, it is most appropriate — and fiscally responsible — to consider the implications of risk over a time frame that extends beyond today’s headlines.
A long-term view of risk
Within Invesco Quantitative Strategies, we have been managing risk as well as return for over 30 years. Throughout that time we have quite deliberately used models that forecast risk over a longer horizon in all our equity strategies. This has led to more stable risk profiles in those strategies because long-term average volatility is simply easier to predict — and therefore manage — than short-term volatility. It’s a bit like the weather. I can’t tell you if it will rain next Friday, but I can tell you with a high degree of certainty that we’ll get an average of about three inches of rain over the summer months.
Reacting to short-term volatility and chasing the accompanying trends can be quite dangerous. First, it’s a certainty that the incremental turnover and related transaction costs will eat into your portfolio’s returns. Second, and even more importantly, there’s a very good chance that you will get whipsawed by the sharp moves — selling after prices have already fallen, and buying back after prices have reverted to former levels. Rather than fret about the right tactical decisions to make against a rapidly shifting backdrop, these times are a good opportunity to reflect on your strategic allocations. Is my risk properly balanced and diversified across strategies? Am I getting the diversification I thought I had? Are there strategies to consider that have historically performed well during stressed market conditions?
Compared to the longer market history, investors have enjoyed a generally low level of volatility since 2012. This may have led to some complacency regarding strategic asset allocation decisions. Given the generally low levels of volatility in recent years, and the uncertainty in the macroeconomic environment, it may be likely that after we get through this current spike, average volatility will creep higher. Therefore, investors and their advisors may want to consider strategic allocations to strategies that have historically held up in periods during which volatility increased and equity market returns were less robust. Should you find an unmet need, it is likely prudent to wait for the dust to settle before making any changes. Volatility spikes, by definition, are short-lived, but regret lasts quite a bit longer.
Kenneth Masse is Client Portfolio Manager at Invesco.
