Paul Sweeting of J.P. Morgan Asset Management explains why radical changes of plan are an unwise reaction to market turbulence.
Chart 2, below left, shows the distribution of returns for the MSCI compared with the distribution that would be expected if the returns had a normal distribution with the same average return and volatility.
As can be seen, the risk of negative returns is higher in the observed returns, as is the risk of extreme returns generally.
Some asset classes are also more volatile than their observed returns might imply. This is due to an issue known as ‘stale pricing'.
If the quoted price of an investment does not change for long periods of time simply because there has been no trade in that investment, then it might appear to offer stable returns.
Assets such as private equity and real estate are particularly affected by this issue.
However, the true underlying volatility of the asset - which determines the true level of risk - might be significantly higher than the observed volatility.
The extent to which this is an issue can be determined by looking at by how much historical returns in one period are linked to returns in the next period, a feature known as serial correlation.
Observed returns can then be ‘unsmoothed' before further analysis is carried out.
Another important aspect of diversification is the extent to which an apparently diversified position can turn concentrated in times of market stress.
This is another way of saying that correlations between asset classes tend to increase when price movements are extreme.
As such, measuring the relationship between asset classes using just correlation ignores the true ‘shape' of relationships.
More accurate techniques such as copula theory can be used to describe the relationship between asset class returns, but the way to deal with the issue is to ensure that assets are truly diversified.
Within each broad asset class, this means it is important to ensure that returns come from as broad a range of sources as possible.
So, for example, in equities this means considering not just global developed market equities but also emerging market equities as well.
However, it is also important to look more widely at the sources of return.
