Investment Strategy after the Crisis

MILAN – Investors have been hit hard by the current crisis. Lessons are being learned and investment strategies revised.

The central lesson for investors seems to me to be that not all components of risk are static, but rather evolve in ways that are not yet fully understood – and that government regulation cannot fully address. For that reason, the ability of markets to self-correct should play a role as well, which requires that investment strategies attempt to take the possibility of systemic risk into consideration.

Threats to the system as a whole can arise in a manner that is difficult to detect, and that can cause risk-mitigation strategies that work well in normal times to malfunction. Of course, major systemic disruptions do not occur every year. Instead, instability builds up until the system is shocked and resets, with the exact timing unpredictable.   This means that addressing systemic risk requires a longer timeframe than that associated with the non-systemic, stationary risks to which investors devote most attention.

Consider a ten-year period and assume that there are nine years of “normal” average returns, followed by a “bad year” caused by the systemic risk component. In that case, as an example, if an investment strategy yields an 8% annual return in normal times, a large shock of 20% at ten year intervals would reduce the average 10 returns by 3.19 percentage points, to 4.81%.