To answer this we should analyze the various sources of risk along time

First, returns since the financial crisis of 2007 have suffered higher volatility -the magnitude of changes in price of an asset in time – with respect to the historical norm. Equity volatility may exceed 20% annually, i.e., its 100 initial value may move throughout a year to 80 or 120. In particular U.S. equity VIX index on S&P500’s is considered the reference. Risks are considered weak when it is less than 15%. Its increase is often synonymous of deterioration of economic activity or aggravation of systemic risk. It stood at minimum of 10% by 2004-2006, when economic growth was strong, but reached 80% during the Lehman Brothers bankruptcy in 2008.

In this sense many observers may be surprised. Between 2000 and 2011, a period of high uncertainty, the markets showed volatility close to the long-term average. The MSCI EAFE index of equities of developed countries outside USA was 19%, similar to the observed from 1971 to 2011. Within large capitalization U.S. stocks was 25% between 1926 and 1971.

Therefore a high volatility is not new

Volatility is also just one measure of risk. We must also pay attention to available liquidity, leverage and above all periods of rapidly falling prices; as the fall of 2008 during the global financial crisis and may 2010, with the so-called flash crash, when Dow Jones Industrial fell about 9% to recover in a matter of minutes. In fact studies have shown that markets are now more sensitive to unexpected or negative news, being prone to sudden fall events.

Now why has vulnerability increased? Studies suggest several factors. First, exchange-traded funds (ETF) have grown a lot lately. They act largely with baskets of securities and simultaneous buying and selling a large  number of an index equities. Consequently the shares of the basket and the index tend to vary with same sign in a trading day with news or unexpected events -that means an increase of undesirable correlation-

Are there other reasons behind the increase in vulnerability of markets? Another possible element is the increased use of indexes as reference in active management, which has increased significantly since 1995. This leads to a concentrated negotiation in shares or underlying securities. Another possible source of vulnerability is the increase of quantitative investment strategies, managed on basis of similar signals, which can contribute to sudden drops.

Finally there is human behavior. As social animals, certain cognitive and emotional behaviors lead us to commit of judgment errors. We often rely on our ability to manage the risk of an investment, which leads to the trap of believing that the future is predictable when it is uncertain.

Whatever are the factors that explain the increased vulnerability of markets the result is a significant reduction of ability of investors to diversify risk. All investments, indexed or not, are now more risky. This affects portfolios management, because a greater volatility, market or company-specific, limit the effectiveness of diversification and and additional difficulty to build an investment portfolio, whatever the style, whether small-cap, large-cap, growth or value.

So investors have to improve their investment processes, incorporating risk in asset allocation. The investor who wants to maintain the same level of risk needs, among other things, a significantly increase in the weight of equities in the portfolio.

Rodney Sullivan, CFA publication director
Jose María Serrano-Pubul, CFA.