The Independent Market Observer

Market Volatility: Optimizing Gains Vs. Avoiding Losses

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 30, 2018 12:51:07 PM

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market volatilityAs you might imagine, I have been thinking about the financial markets quite a bit in recent days and trying (as we all have) to figure out what comes next. As I went through this process, though, it occurred to me that this is a great chance to evaluate how we think about the market as well. So for today’s post, let’s do both.

Taking the outside view

I started with the outside view. Daniel Kahneman defines this as an analysis that looks at similar situations, rather than at the specifics of a given situation. When we look at pullbacks in history, for example, we find that in the absence of a recession or other aggravating factors, they tend to be short even if sharp. That was the thinking behind my original conclusion, at the start of this pullback, which was that the pullback would likely be both limited and short. That conclusion, mind you, is still quite reasonable. The drawdown has only just cracked the correction mark, with a 10-percent drawdown. This turbulence is still a bump in the road and may well end up as just that.

As markets kept dropping, though, the risks appeared to be rising—and I will admit I was and am less certain of my original conclusion. I started to pay attention as the S&P 500 broke its 200-day moving average trend line, which has historically been a signal of potential trouble. I started to worry when it got close to its 400-day trend line. The 200-day often gives false signals; the 400-day is more reliable and would have signaled a potentially worse drawdown ahead. Not that it is infallible, but breaking that trend line would markedly increase the chances of more trouble ahead. We have not, in fact, broken the 400-day. So, that remains something to worry about and not yet something we have to deal with—but we are getting close.

You can see here that two outside-view analyses seem to conflict. Both have good track records, both are reliable signals, and both may be indicating different things. While the conflict is more apparent than real, trying to resolve it would take us into the realm of the subjective—and back into guessing.

Nonetheless, as decision makers we have to resolve it, and we can look at decision-making theory to help us out. First, we have to decide which risk we prioritize: missing out on future gains or participating in future losses. If we prioritize gains, then we should not worry about the drawdown and stay with the outside view that it will be limited and short. If we prioritize avoiding losses, then perhaps we want to consider the trend line analysis, despite its shortcomings.

Rely on the formulas

One way to do this is to rely on formulas. Again, per Kahneman, “the research suggests a surprising conclusion: to maximize predictive accuracy, final decisions should be left to formulas, especially in low-validity environments.” I find this to be useful in resolving the apparent conflict between the two outside views. In fact, this is the approach I took in my book, Crash-Test Investing.

Here, the initial argument states that pullbacks are likely to be short in the absence of a recession, but it doesn’t speak to how deep they can be. Indeed, both 1962 and 1987 fit this argument well, and no one would want to go through either one again. The trend line argument, however, speaks only to the depth of the pullback and not its length.

Depending on what you are most concerned about, either could be appropriate. Given current economic and market conditions, any pullback remains likely to be relatively short but could well be quite sharp within that time frame. Short is also a fairly undefined term. The trend line outside view suggests that the pullback could indeed get worse, especially if the indices drop below their 400-day moving averages. Using these analyses, the balance of risks for a larger drop has clearly increased, even as the most probable result remains a recovery.

So, what should we do?

The answer hasn’t changed. If you want to optimize long-term returns, ignore the market and stay invested. If you want to manage volatility, now might be a good time to consider derisking your portfolios. Either way has both costs and benefits. But now would be a good time to think about which way you want to go—and to act accordingly.

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