Volatility and Investment Strategy

A correspondent writes:

Take a look at the FTSE 100 over the last 25 years and give some thought as to how an investor should respond to the much more volatile and cyclical characteristics of the stock market over the last 10 or 12 years. In my view the market has changed fundamentally over the last decade but investment strategies for the average man in the street have not changed at all – they still simply buy and hold. I should be interested in your thoughts.”

My immediate thoughts are these:

  1. Structural volatility might have arisen from (a) volatility of demand patterns (hot money, speculative derivatives, programme trading) or (b) volatility and uncertainty in company cash flows, or both.
  1. Volatility is as likely to give rise to amplified losses as amplified gains.
  1. However, the pattern has actually been high levels of ‘market memory’, or ‘dependence without correlation’, leading to extended periods of upward or downward regression punctuated by clusters of extreme volatility.  This has happened fractally-in-time.  The same pattern (at a smaller scale) has been visible within a trading day as over a decade.
  1. If volatility arises from (1a), the buy-and-hold model is more relevant, not less, provided the investor can reach an informed view on the intrinsic value of the underlying company (ie he is an educated value trader).   Volatility is an opportunity.  He has no business taking an equity risk in the first place without understanding intrinsic value.  However, (3) implies that the balance of ‘sell’ decisions will change relative to ‘hold’ decisions – there are more instances of price being well in excess of intrinsic value, a position which can and does take years to recover, so selling is rational.  Buy-and-hold is fine; fire-and-forget is not.
  1. If volatility arises from (1b), he may not be able to form even a rough view of intrinsic value, even if ‘sophisticated’.
  1. So he can hedge, diversify or manage volatility through ‘reverse gearing’.
  1. The ‘man-in-the-street’ may be unable to hedge effectively, so may have to rely on fund managers who can.  (He might hedge crudely across asset classes – say equities and gold.)
  1. He can diversify, but high volatility implies high levels of dependence and correlation, which in extremis may invalidate altogether the portfolio effect and neutralise any benefit from diversification.  It may even make matters worse.  This assumes of course that he is seeking to reduce his risk in the first place – see (2) above.
  1. So his best strategy is to adjust his balance of equities and cash funds.  If equity volatility doubles, halving the amount invested in equities and reallocating this to cash will, all things being equal, deliver the same return.
  1. Finally, if handing funds over to management, he may be best advised to find a manager who uses multi-fractal techniques for forecasting and diversifying volatility clusters and/or uses derivatives which hedge specifically against volatility events.   Good luck with that one.

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