Paul Sweeting of J.P. Morgan Asset Management explains why radical changes of plan are an unwise reaction to market turbulence.
The recent market turbulence will have put many pension schemes’ asset allocations under the spotlight.
However, it is important not to act in haste while there is so much uncertainty out there.
While there are some housekeeping steps that should be taken – regardless of market conditions – the best response at times like this is to stick to whatever plan you have, making only strategic adjustments.
There are two reasons for taking this view. The first is that while it is difficult to predict the direction in which markets will move on a day-to-day basis, it is easier to predict levels of volatility.
In particular, large market movements on one day are likely to be followed by further large market movements on the subsequent day – in other words, volatility clusters, as can be seen from Chart 1, below, which shows the daily price moves in the MSCI World Index.
The clusters of volatility can clearly be seen but, more importantly, so can the recent large increase in volatility at the far right-hand side of the chart.
The reason this is important is that it means there is a greater entry point volatility – in other words, volatility around the price at which you buy and sell.
While this might mean that a large change in asset allocation at this point in time could turn out to be the best decision you ever made, it could also prove to be the most costly.
The second reason not to make dramatic changes now is that it is strategy that gets a plan from where it is to where it should be – it should not be torn up in times of market volatility.
A strategy should not be immune to significant market events – it might be that contributions have to increase or timescales need to be moved back.
However, any amendments should be changes to the long-term strategy, not just tactical changes to the current allocation..
There are, however, steps that can be taken now based on what we already know about asset class returns.
The most important of these is to ensure that returns are adequately diversified.
This is particularly important given that the risk of extreme negative returns in many asset classes is higher than implied by the normal distribution, and so higher than many investors might expect.