Financial markets frequently feel like the morning commute on a major city subway system. When the weather is sunny and the trains are running smoothly you are all smiles and your mood is upbeat. But, watch out if you are experiencing weather delays and personal space is compromised. Your mood and that of your fellow travelers darkens considerably and your thoughts switch immediately to how to escape the situation.

Investors likewise frequently feel this tug of war between one moment being upbeat and confident and the next being rife with doubt and stress. Back in 2009 Mohamed El-Erian then at Pimco described the changing mood swings of investors using the risk on/risk off label.

While the risk on/off concept makes a lot of sense to truly grasp the investment implications of such mood swings one needs an objective yardstick to properly identify these periods of euphoria and sheer despair.

Most of the methodologies that researchers have used to identify investor mood swings employ measures of general uncertainty regarding asset class prospective performance, credit conditions and broad macro-economic health.

The technical details separating one system from the other would put most investors to sleep, but in general my observation is that all these “investor mood” models are directionally correlated. For example, the period 2004-2006 is generally classified as upbeat while the period from 2008 through 2009 is generally described as harrowing.

At Global Focus Capital we call our proprietary system the Risk Aversion Index (RAI). The higher the RAI the more fearful investor are, or in other words the more risk averse. We calculate this measure daily and sometimes, given the rapid mood swings, we have come to think of market participants as suffering from multiple personality disorder. However, on a kinder note what we generally observe is that investor mood tends to reside, over the intermediate-term, in defined ranges of risk aversion.

Let me illustrate what I mean by referring to Figure 1. The first thing to notice is the choppiness of the Risk Aversion Index (grey area). This clearly provides empirical support to the concept of risk on/off. Investor mood is highly volatile and switches sometimes rapidly from euphoria to despair.

The second thing to notice is the tendency over intermediate time periods to remain in a defined range of risk aversion zones. We use a 200 day moving average to smooth out the daily ups and downs and better visually this clustering effect. While investor moods are ever changing, in general, we see long periods of time when investors are much more tolerant of risk and similarly other periods when investors crave above all else for the safety of their capital.

Figure 1

Let me elaborate further. For simplicity we classify our RAI readings into three risk zones – a Risk Loving Zone (defined as the bottom 25th percentile of observations) where investors are usually dismissive of potential adverse developments and are willing to accept less return per unit of risk. The period 2013-2014 accurately describes this low risk aversion environment. Many observers would attribute this indifference to risk as a function of the very loose monetary policy of the day. Similarly the years before the 2008 Financial Crisis exhibited a strong downward trend in risk aversion.

The second zone (middle 50% of observations) labelled the Neutral Zone is the area where investors some days feel good and on others feel a bit down but in general there is a healthy balance between risk and potential return. This middle zone is one where investment strategy is preferably based on longer-term fundamentals and less influenced by the prevailing capital market risk environment.

Finally, we define a Risk Allergic Zone (top 25% of observations) where gloom and doom is the order of the day. The periods surrounding the bursting of the Tech Bubble and the Financial Crisis of 2008-2009 best illustrate occurrences when investors suffered from such a high aversion toward risk.

What does it mean to be in each one of these risk zones? Without going into all the portfolio construction issues (which we will explore in a separate note) let us just focus on returns.

In Figure 2 we illustrate average monthly returns since 1995 for the major asset classes typically part of our asset allocation strategies at Global Focus Capital. Among equities and fixed income we split the asset classes into domestic and international and also always include alternatives such as real estate and commodities.

Figure 2

Periods of capital market stress such as those when the RAI is in the Risk Allergic Zone (red bars) are difficult for investors holding riskier asset classes such as equities. In line with conventional wisdom the higher the perceived risk the more negative the average returns. When the RAI is in this zone all equities suffer but emerging markets takes the biggest hit (down 2.3% on average). Our two alternatives (Real Estate and Commodities) also take a hit but the overall negative effect is dampened due to their exposure to non-equity risk factors.

Fixed income on the other hand tends to exhibit positive average returns during this high risk aversion phase. In fact, the highest average returns of all asset classes correspond to government bonds (US and Non-US developed market). US Government bonds for example show an average monthly return of 1% in the Risk Allergic Zone.

Let’s see what happens when the RAI falls in the Risk Loving Zone (green bars). Here the situation is reversed. Asset classes with higher perceived risk tend to do better. Emerging market equities do best on average and small caps outperform large cap stocks. Real estate also does well. Within fixed income emerging market bonds do best, but in general the performance of safer assets lags significantly behind that of riskier investments.

When in the Risk Loving Zone it pays to be aggressive, but one must also be mindful of taking on too much risk in exchange for less and less potential reward. Both the Long Term Capital Management implosion in 1998 and the 2008 Financial Crisis debacles occurred on the heels of investors being highly dismissive of the risks involved. In both cases investors were taking on a disproportionate amount of risk for smaller amounts of potential return.

Finally when evaluating returns in the Neutral Zone (orange bars) it is interesting to note that, on average, equities tend to exhibit the best monthly returns when in this risk phase. All four equity classes show this tendency. Likewise real estate also shows the highest average returns in the Neutral Zone. Interestingly, the highest perceived risk asset within fixed income – Emerging Market Debt – also shows this characteristic.

Where is the RAI now and what should we be doing? Our barometer is currently entrenched in the Risk Loving Zone with a reading in the 20th percentile. The RAI has been trending up (becoming a bit more aware of risk) but despite headaches in Europe we are still seeing very low levels of risk aversion.

We suspect that the expansionary monetary policy in the US, Japan and Europe is artificially depressing capital market volatility and that the temptation to remain aggressive (and potentially take on leverage) is driven by the exceptionally low cost of money. We remain wary of too good of a thing and the quietness of the capital markets concern us. We believe that investment performance is most aligned with fundamental trends when investors display a healthy risk to return relationship such as when in the Neutral Zone.

What could trigger a change in investor mood? Potentially a whole host of issues frequently best understood in hindsight. But on a more practical note we would highlight two areas of concern. First, while highly anticipated, we think that investors will react negatively to the first increase in the Federal Funds Rate and risk aversion will jump up sharply. The second concern involves contagion effects should a Greek default occur. At the very least the interest spread between safe and riskier debt should jump up. This would lead to a higher RAI and riskier investments will likely bear the brunt.

On a final note, we believe that investment risk is being underpriced at the moment and that there is no better time to evaluate one’s willingness to trade off risk in relation to potential reward. Monetary authorities have provided investors with a nice safety cushion and allowed aggressive investors to benefit disproportionally, but the ride is nearing an end at least in the US.

Eric J. Weigel

Managing Partner

Feel free to contact us at Global Focus Capital LLC (info@gf-cap.com) to find out how we can help with your investment needs. You can also download this report in PDF format or sign up to receive future ones by email below.

Three Things You Can Do To Lessen Your Fears

After the harrowing experience of the 2008 Financial Crisis investors have acquired a heightened sensitivity to market dips.  While global economies have for the most part recovered, trouble spots still loom on the horizon and global macro-economic conditions remain frail in the eyes of most investors.  Investors have benefitted from the recovery of equity and fixed income markets, but market participants now fret about over-valued conditions and a lack of yield.

In general, on the surface there is an uneasy sense of calm prevailing in the markets, but anecdotal evidence points to a general climate of investor nervousness.

While the timing and severity of market meltdowns is impossible to forecast with any reasonable degree of accuracy, investor can take action to better prepare themselves for the inevitable turbulence ahead.

One option is to Review Your Strategic Asset Allocation Plan:  The first and most important action that investors can take is to thoroughly evaluate their total investment portfolio in relation to their goals and risk appetite.  Large institutional investors such as pension plans regularly conduct strategic asset allocation reviews that determine broad asset class exposures and appropriate risk levels in relation to a plan’s stated goals and ability to withstand capital market shocks.

Individual investors are no different from large institutions in the need to regularly assess if their portfolios are structured in a manner consistent with their current goals and their stomach for sudden losses in capital. As Yogi Berra once said “if you don’t know where you are going, you will end someplace else”.

Knowing what you want and how much pain you are willing to incur is the starting point for structuring an investment program that removes worry and deals with what is in your control.  The day to day vicissitudes of the capital markets are beyond anybody’s control so action item one is to strategically look at your portfolio for its fit with your goals and willingness to tolerate capital losses. If there is a good fit you have done everything within your control.

In the short term, nothing guarantees against disappointing outcomes, but over the long-term capital markets tend to exhibit certain tendencies such as stocks outperforming bonds but with more interim volatility, credit strategies outperforming government bonds again with more volatility, and money market investments being the safest but lowest yielding asset class.  A well designed strategic plan should allow the investor to lessen their fears and only make adjustment as circumstances change.

Another course of action is to Buy Protection on Your Portfolio:  Just like people buy insurance policies to protect them financially against adverse events such as a house fire, a flood or the death of a parent, investors can structure an insurance plan covering their portfolio. There are many different flavors of insurance available to investors. The type of insurance strategies most commonly used by investors are not contractual in nature and thus do not guarantee a firm floor for the losses.  Instead strategies are designed to “hedge” against severe negative portfolio outcomes on a best efforts basis.

The specific features of the hedging program involve determining the potential maximum expected loss (think deductible), the assets covered, length of coverage, hedging tools employed, and finally the expected cost of the program.  Barring highly unusual capital market conditions, portfolio insurance programs involve a cost to the investor (think premium).

Typical hedging vehicles include exchange traded derivatives on indices.  The strategies could involve buying a put option on the S&P 500 to protect against major adverse equity market developments, or shorting a T-Note futures contract to offset the harmful effects of interest rate increases on a portfolio.  The specific strategy would optimally be calibrated to the investor’s portfolio, but in recent years we have seen the issuance of several inverse ETF’s (see PSQ) and  rules-based products (see PHDG ) designed to provide generic hedging capabilities.

In all cases, the assumption is that there is a negative correlation between the performance of the hedging strategy and the portfolio one is trying to protect.  When the portfolio takes a hit the idea is that the losses would be partially offset by gains on the hedging vehicle.  Portfolio protection programs typically come at a cost and the quality of the protection is highly dependent on the structure of the program and the degree of customization involved.

Finally, Use a Tactical Asset Allocation (TAA) Overlay.  Such an approach is predicated on the ability to identify periods of time when capital markets relationships appear distorted.  The approach involves removing exposure to certain asset classes (the menu typically involves stocks, bonds, cash, real estate, commodities and alternatives) when the likely profits are minimal in relation to the risk taken, and conversely adding exposure to asset categories when, for some reason or another, the risk of doing so is low in relation to the potential reward.

The trigger in most TAA programs for making portfolio shifts are changing expectations for asset class returns. In addition, shifts may also be driven by the changing risk profile of the asset classes as well as the overall risk aversion of capital market participants.

TAA provides portfolio protection by skillfully adjusting the exposures of asset classes in the investor’s portfolio.  Typically, TAA programs work in conjunction with the longer-term plan of the investor by incorporating measured deviations from the set of exposures prescribed by the strategic plan.  The TAA program will, in theory, dampen the short term downside volatility of the overall portfolio while still allowing the investor to enjoy the long-term rewards of the strategic plan.

TAA is a skill-based active approach to portfolio management and as such can offer the dual benefits of enhanced returns (due to the tactical shifts) and lower interim portfolio volatility, but in the absence of skill there will be a cost associated with the activity.  Sometimes the cost will be in terms of missing out on unusually positive returns (if the TAA strategy is positioned too defensively) and at other times the cost will come from incorrectly tilting the portfolio toward asset categories with disappointing performance.

“Thinking will not overcome fear but action will” as W. Clement Stone once said. All three action steps mentioned above will lessen your fears, but the greatest contribution to your financial well-being is forming a strategic asset allocation plan.

Examining your goals and willingness to take risk and structuring your portfolio accordingly is the key action step that will allow you to more confidently navigate through the inevitable market ups and downs.  A solid risk management approach to investing and a tactical ability to adjust to temporary capital market dislocations will enhance only enhance the hard work of planning ahead.

Eric J. Weigel

Managing Partner

Download PDF Version of Report: Worried About Your Investments – Global Focus Capital – June 2015. Feel free to contact us at Global Focus Capital LLC (info@gf-cap.com) to find out how we can help you with your investment needs.