Active Management of Downside Risk During Long Market Cycles
Investors should avoid complacency, as higher volatility brings new opportunities.
Historically, investors’ behavioral bias toward taking on the riskiest assets has driven high volatility (while suppressing long-term returns). The decade from January 2010 to January 2020 was one of the most favorable environments in 120 years of market history. It was a decade of unusually low volatility, exceptionally high return, and consistent upside in markets. The long-term history of markets has also shown us how investors get complacent, and we are seeing signs today of investors over-extrapolating the good times far into the future, leading to a substantial re-rating of market valuation. Downside risk remains very real, as uncertainty around inflation expectations continues to increase alongside a possibility of policy errors. Furthermore, volatility has settled on a new medium-term average in recent months. Typically, higher volatility allows for opportunities to add value as an active manager. And regardless of directional moves in the market, volatility will remain a key player in markets for the foreseeable future. Investors should come to terms with the fact that returns will be scarce going forward and, additionally, they should also heed the dangers of excessive equity risk. Equity risk has to be managed diligently and carefully, paying attention to the less-visible risks. Returns will be more scarce and the investor’s path likely more ridden with pitfalls, so an active approach where the various permutations are examined meticulously is appropriate.