The reason for this is that financial markets are a complex system of the most complicated and unstable sort. This stems partially from the fact that its structured as a (massive) network without fixed flows of information, in which all dots can potentially interact and mutually share information. This makes the equilibrium or “outcome” that emerges in the market organism already much more difficult to understand than more mechanical input-output organisms. Still, with enough sophisticated calculation power the behavior of some networks can be fairly well understood, especially if they operate in a controlled environment, like a computer network.

However, as soon as human emotion and interaction becomes part of the information exchange another layer of complexity is added, because all kind of feedback loops are introduced whereby actual behavior of other or expectations about others or the eventual outcome of the system, influence the behavior of humans/investors at this very moment. This creates the possibility of self-fulfilling expectations, irrational and inconsistent behavior and unstable causalities in the way dots (yes, that’s investors in this case) in the system influence each another. As a result of this, a certain input, shock or external source of new information can never be trusted to generate a certain result (“outcome”).

At one point in time, certain economic date or political/policy news might have a positive impact on investor sentiment, while at another it might create the opposite. Some of these types of relationship might still seem more stable than others, but none of them can ever by fully trusted. Policy easing and strong economic or earnings data are probably often seen as positive, but if they are interpreted as either too little (easing) or too strong (data) compared to expectations that have (for whatever reason) been build up in markets, it can also easily translate into negative market sentiment.

Moreover, human emotions and interactions can also create expectations that are completely detached form underlying fundamentals, but still drive collective moods swings that are translated into market volatility. The latter often creates asset price moves that are even after the fact very difficult to understand. The most well-known example of this was the global stock market crash of October 19th, 1987 (when the Dow Jones Industrial index dropped 29.2% on the day!), for which no fundamental reason could be found, both before and after the event. Even the explanations that focus on a combination of factors such as human emotion (irrational panic), technical (phone, IT) glitches and unexpected lack of liquidity at broker-dealers provide little understanding on the timing and size of the event.

So, tuff luck. We operate in a complex world where unexpected things should be expected, but timing and severity can never be known in advance. As an investor there are(at least) two things that can be done, however, to deal with this reality. First, you can prepare for the unexpected and aim to make portfolios as robust as possible.

Simply put, this can be done by aiming for diversity in risk taking across asset classes and creating a good balance between “safe” assets (which bring positive returns in high volatility regimes) and risky assets that generate returns in calmer market environments. Important principles to keep in mind in the associated portfolio construction process are not under-estimating risk and not over-estimating diversification benefits.  

Second, investors can react to a shock. Depending on one’s assessment on the persistence of the volatility-regime, the likelihood of fundamental drivers behind it or the observation of substantial feedback loops from markets to the underlying economy, portfolios can be adapted. Sometimes a spike in market turmoil is only the start of a longer lasting storm (for example the collapse of Lehman in September 2008), while more often it creates an attractive investment opportunity. For example, nearly each time the Vix index has jumped above 20 over the last 2 years it proved to be an attractive buying opportunity for risky assets.

With respect to our asset allocation stance, we have been focusing on the needed direction of change in our stance in recent weeks. As we see it, the correction in markets was remarkable, but very difficult to explain on the back of underlying fundamentals. Fears over the European economy and the willingness of European policy makers to manage deflation risks and provide the much needed stimulus to growth played a role. Also, broader global growth worries, Ebola fears and lingering concerns on the stability of the Chinese seem to have influenced investor risk appetite.

However, none of these issues where really new and economic data mainly pointed to a rising divergence between (softening) trends in Europe and (strengthening) trends in the US. The underlying outlook for global growth, however, did not materially change over the last couple of weeks in our opinion. The fast and large move of the market was therefore probably largely driven by technical factors like profit taking on crowded trades, increased market fragility due to weakened liquidity conditions and an overshoot in negative sentiment amongst active players in the market.

This assessment prevented us from reducing our overall risk stance in recent weeks as we mainly focused on identifying the emergence of new opportunities. As one of the consequences of the recent macro and market dynamics is a lower inflation outlook and (even) easier monetary policy stance globally, we feel that most opportunities have been created in interest rate sensitive part of the market. Therefore, we have rebalanced some of our risky asset tilts from equities towards real estate and fixed income spread products. Also, government bonds remain supported by the “search for yield”-theme and, importantly, proved again recently that even at the current low level of yields these type of assets remain a popular destination for safe haven flows in periods of risk aversion. After the recent period of market turmoil, we prefer to take a balanced approach. This means holding government bonds and also remaining tilted to income generating risky assets.