This series intends to illuminate a pathway that will help advisors safeguard their practices and investor accounts. At StratiFi, we believe in a much greater focus on defining and managing risk. A risk approach is widely used among institutional investors, but many individual investors and advisors do not broadly understand the concepts and disciplines. In this article, we will elaborate on the myth that diversifying a portfolio decreases the risk of volatility:
Once, when the world was simpler, and markets moved slower, a portfolio that was built around a combination of stocks and bonds could withstand almost any financial shockwave. But diversified portfolios are no longer reliable bomb shelters for money as the global financial crisis and the worldwide COVID-19 crisis have shown investors and advisors alike.
Diversified Portfolios Lessen Volatility
Technology and international trading agreements have turned the world into a global flow chart for capital. Investors now follow the sun as it rises and falls, perpetually trading stocks, bonds, commodities, and derivatives over sophisticated computer networks that are at the heart of a financial market that barely sleeps. This interconnected financial world is increasingly only understood by complicated algorithms that make more decisions in a fraction of a second than most people can process in a week.
These computers understand all of the relationships between asset classes, and within and between sectors, and even capital structures. Through machine learning, computers learn from what transpires or does not transpire in the market. Those insights, hidden from the naked eye, are used to uncover new ways to successfully invest. Everyone else, including the SEC and other financial regulators, lacks a coherent understanding of what transpires in the markets. This introduces meaningful disconnects, and arguably structural weaknesses, into the financial system.
Consider the basic nature of stock exchanges. They were originally created to help companies raise capital that could be deployed to build and grow companies and thus expand the real economy. Now, stock exchanges are high-speed computerized trading networks that are under extraordinary pressure to ensure that their markets are friendly to high-speed trading firms. This has created a technology arms race that is damaging the historical principles of fairness and transparency upon which the markets have been built and historically regulated.
Trading firms are increasingly influential members at exchanges. These firms are under extraordinary pressure to trade faster and faster to keep up with the extraordinary pace of trading. This focus on speed, and accommodating the trading styles of institutional investors, has encouraged the most sophisticated investors to protect their assets by continuously pricing, and repricing, risk, and the potential return in response to economic data and corporate, political, and social news in Asia, Europe and America. Everywhere, there is an increased awareness of relationships and how that might impact equity values and risk. Against this backdrop, a portfolio predicated on diversifying money between stocks and bonds is the financial equivalent of black-and-white television and a rotary phone. The key problem is that too few people are aware of that.
Institutional investors know that tremors in the bond market, for example, often alter the stock market. Spreads on Credit Default Swaps, or CDS, which are used to insure corporate bonds, regularly roil stock prices and the implied volatility of associated options contracts. Twenty years ago, cross-asset contagion was rarely mentioned as a cause for erratic stock and bond prices, but now it is common. Banks even employ cross-asset strategists to monitor how actions in one market influence prices in another. In this
interconnected financial world, bonds are no longer the antidote to the risk of owning stocks. Sometimes, bonds are as risky, and maybe riskier, than stocks. This is especially true in a rising rate environment. In those conditions, diversification is a wolf in sheep’s clothing that can turn into a bear unless investors develop strategies for managing the downside, as well as the upside.
In the absence of a proactive approach, investors are fully exposed to the market’s many risks and must make up any losses before they need the money in their investment accounts to provide for retirement expenses, send kids to college, or cover unexpected expenses.
“Diversified” portfolios don’t protect against increases in volatility.
Broadly allocated portfolios look diversified on the surface, but during times of heightened market volatility, they commonly fall in unison—or exhibit short volatility traits. Short volatility exposure generally delivers losses as market volatility increases, while long volatility exposure generally delivers profits as market volatility increases. Option overlays can balance the portfolio by adding long volatility exposure.
Our PRISM™ risk analysis software uses a blend of risk tolerance questionnaires, historical market events, and current market signals to provide advisors with all the data they need to know their customers and plan accordingly. Contact us to find out how StratiFi can help your practice.