Active Markets and Active Asset Mix

Recently, volatility in the markets has reared its ugly head. Last week the VIX rose to over 40%. We can be thankful that is only about half of what it was at the height of the crisis last year. It is still double what it has historically been. A normal level appears to be between 15 and 30. I recently read an article by Brian Jacobsen in the March April 2010 issue of the CFA Magazine about Asset Allocation in Crisis where he defined the VIX as an imperfect measure of investor myopia or fear. “The VIX on the S&P 500 is the implied one-month volatility (annualized standard deviation of returns) on the S&P 500 calculated from various options on the S&P 500. This is sometimes called the “fear index” because its value tends to increase when investors are looking to purchase insurance (e.g. put options) on a portfolio.” Ironically as I write this article I am on an airplane to Ottawa and the seatbelt sign went on with the flight attendant announcing we are entering a period of turbulence. As we enter another period of increased turbulence in the market, you would be well advised to listen to the flight attendant and do up your seatbelt.

Most investors use asset allocation as their seat belt. A commonly held belief is that 100 minus your age is an appropriate asset mix for you, some investors start with the market and adjust their mix according to their risk and return expectations and some base it on income needs. No matter where your starting point, the world is a changin’. Therefore we believe it is important to be flexible and be active in your investment approach. That doesn’t mean you should be going to cash whenever you get that gut feeling the markets are headed to the dreaded place after life. It is important to establish some ranges to work within that you are comfortable with.

In my world, this is established through an investment policy statement. This should be consistent with your risk and return objectives and any constraints you need to adhere to. Some of those constraints may include your time frame, income needs, legal or tax concerns, environmental concerns and liquidity needs. An example of this in a balanced mandate, where your long term target asset mix is 50% is stocks, 45% in bonds and 5% in cash, you would have a range of 20% plus or minus your target. In stocks your range would be from 30% if you were bearish to 70% if you were bullish. This way at least you can attain your long-term target returns even if you get it wrong on your asset mix call. For example, last year the market went up and you may have been on the lower end of your asset mix range. Generally speaking you would have captured 1/3rd of the rise of the market versus ½ or ¾ if you were lucky enough in a balanced mandate. However it is better to miss the ½ or ¾ on the way up if you avoid that on the downside. An example of this is if you have $100,000 and it drops to $50,000, the drop is 50%. In order to get back to $100,000 you have to earn $50,000 on that $50,000 which is 100%. Assuming you get it right and use some discipline and rules in your decision-making it can payoff to be active but with some protective devices in place. An investor’s asset allocation should be dynamic within parameters that suit your individual needs and market and economic conditions.