After the UK referendum on EU membership, attention for many now turns to the next “event”: perhaps the next meeting of a major central bank, Italy’s referendum on constitutional reform, or the US presidential election. You can be certain each of these events will generate considerable media coverage and opinion. Many commentators will argue that each event in turn is critically important for investors.
Anyone involved with markets for long enough will be familiar with this never-ending stream of important events, each of which can dominate investment commentary and conversations for brief periods; often to be quickly forgotten.
This phenomenon appears symptomatic of particularly acute myopia among market participants, seemingly more so than usual these days. Whether this be the result of genuine or perceived uncertainty, a growing obsession with scrutinising short-term portfolio volatility or the influence of media trends (and our use of media) is hard to say. But we can be certain myopic behaviour abounds. One sell-side strategist this week commented: “The Italian constitutional reform vote still looms large, but is seen as a post-summer phenomena [sic]”. A whole three months away!
So, as portfolio managers, how should we think about dealing with event risk? There are a number of points to bear in mind:
- It seems likely that when an event is the widespread focus of attention, there is an even smaller chance than usual of having an edge in terms of predicting the outcome.
- Even if you correctly forecast the outcome of the event in question, you might be surprised by the market reaction. There were not many strategists arguing last month for investors to increase exposure to equities because they thought Brexit would happen.
- The intensive attention paid to specific events is a reminder of Daniel Kahneman’s acronym WYSIATI: “what you see is all there is”. It is a human tendency to focus on information in front of us, even if it forms an incomplete picture. Letting the most visible events dominate your thinking can cause you to miss more important developments taking place away from the media glare, developments which you might well have a better chance of forecasting.
- When confronted with the desire to protect against event risk we need to ask ourselves the nature of the risk we are trying to protect against. Short term volatility is not something many of us should fear; if anything it is a source of opportunity (a fundamental concept of our Episode approach to investing). Events with more profound long-term outcomes are something to consider more carefully.
Even so, for the most part, the deeper long-term structural regime shifts that occur typically form over long periods of time, punctuated by a series of seemingly unremarkable developments in real time. We believe time is better spent trying to understand these shifts than to focus myopically on a series of upcoming events. It comes with the benefit of being more interesting and less emotionally exhausting.
Managing downside risk
The above arguments suggest an investment approach which frequently switches positioning ahead of event risk is unlikely to be particularly successful.
However, those investors with a legitimate desire for low portfolio volatility will at times want to mitigate potential downside in anticipation of event risk. Under such circumstances, a sensible approach would be to:
- Scale back positions to provide some dry powder in case excess volatility provides attractive opportunities to add to longer term themes; and
- Seek assets which, in your judgement, will provide an asymmetric return profile and negative correlation to the existing portfolio. Options immediately spring to mind but they are unlikely to come cheaply at such times: when you are most worried about downside risk it is likely that others will be too. Identifying other diversifying assets in such circumstance will rely on good judgement as much as science. Occasionally, if consensus opinion is heavily skewed in one direction ahead of an event it may even be worth taking the other side.
The future is always uncertain…and it always was in the past. Event risk will be something that always confronts us.
Worrying about what might happen as a result of unpredictable short term events is likely to be costly in terms of investment returns foregone over the longer term. For investment strategies with explicit low volatility objectives, the challenge is to mitigate risk as cheaply as possible. But over the long-run, the cost is not zero.