Again and again the markets go through phases of euphoria. As prices rise, so do the risks. Yet common risk metrics barely reveal them. Prof. Dr. Stefan May has now developed metrics – “herd risk” and “real risk” – to make the dangers more visible. In this interview, our Head of Investment Management explains why these metrics underscore the value of diversification.
In investing, volatility is one of the frequently used metrics for measuring risk. It indicates the intensity of price fluctuations around a mean value. Is there something wrong with it?
There's nothing at all wrong with the metric, as long as you interpret it correctly. It captures certain risks. But not all of them. What it does not capture in particular is the increasing risk that results from market exaggerations. We have called this phenomenon, which hardly anyone disputes, “herd risk.” It becomes problematic when volatility is used as a metric to derive an investment strategy from it – that is, for example, to steer the equity share of a portfolio according to the rise and fall of volatility. Because volatility risk measures only a part of the total risk.
So what's the effect when, as an investor, you orient yourself by volatility?
Anyone can observe the phenomenon: when prices climb for a longer time, investors become ever bolder, take on higher risks and tend toward herd behavior. Investors then often concentrate in the segments where prices are rising particularly dynamically. But if volatility is measured over the short term, it falls very markedly precisely in these phases. So the metric suggests a low risk level. When prices fall, investors perceive the risks again and often react frantically. There are sharp losses in the segments previously driven by euphoria. Volatility spikes abruptly. If you orient your investment strategy by short-term-measured volatility – and that is not so rare – you always act procyclically. You run straight into herd risk. We have worked out a metric for this. Together with volatility, the real risk can then be determined from it.
But why can't I simply ride rising prices as long as a trend lasts – and then get out when prices fall?
If only it were that simple. Empirical studies show again and again that investors miss the re-entry and then end up worse off on balance than if they had stayed invested. First of all, you have to determine an exit point. Let's assume you sell when prices have fallen by 20 percent. Then you may already be realizing a loss. When do you get back in? The ideal moment can only be determined in hindsight! Market timing – that is, the attempt to determine the right moment to get in and out – doesn't work. There are entire libraries of studies that prove it.
What does the “herd risk” metric contribute to your investment strategy?
What's important is: this metric, too, says nothing about the right moment to get in or out. We don't derive any timing decisions from it. But the metric can once again show how important the diversification of a portfolio is. Precisely in phases of exaggeration on the markets, the basic rules of diversification are frequently overlooked and disregarded. That has to do with the risk aversion that then declines. Investors focus even more strongly than usual on comparing returns and preferentially invest in segments that have performed particularly well. Diversification then tends to get neglected. That's why we think it's very important to demonstrate the advantages of diversification in a fact-based way, also and especially in such market phases. And that is exactly what we can do with our metrics “herd risk” and “real risk.” We intend to publish them regularly in the future; preparations for this are underway.
And how do you ensure the greatest possible diversification in the portfolios?
We want to cover the entire international equity market as representatively as possible at all times. It is scientifically proven that a global portfolio, spread as broadly as possible, is superior to any alternative investment strategy, particularly in terms of its return-risk ratio. To get as close as possible to this global market portfolio, we use various factor indices that we have determined through an elaborate process.
More on the topic of “factor indices” and how quirion uses them is explained by Prof. Dr. May here.
