Fingers of Instability and Downside Protection

In order to satisfy my acute nerdy side, I often immerse myself in scientific studies. After reading a recent article by the renowned financial expert John Mauldin, I became so intrigued that I had to share it with you. His article is based on a study proposing “Fingers of Instability” and let me assure you, you will not be bored.

Conducted by a brainy trio called Per Bak, Chao Tang and Kurt Wiesenfeld, the study explored the idea of “Self-organised criticality”. They proposed that large interactive systems often organise themselves automatically into a critical state. At this state, any small changes result in chain reactions affecting many elements within the system.

For example, if you dropped grains of sand eventually you would create a tall pile. And at some point you would drop a single grain of sand that would cause the pile to collapse. Now ask yourself a question, “If I drop sand grains onto the same spot continuously, which specific grain of sand would eventually cause the pile to collapse?” Shrugged your shoulders? Then your intuition is correct.

To come up with an exact figure is futile – the process is effectively unpredictable and showed up in their famous sand pile game. Actually, Bak and colleagues generated the experiment on their computer rather actually dropping grains of sand. They conducted this experiment numerous times and obviously a computer does this much faster, with observations better recorded.

Quoting from John Mauldin’s article this is what they found (note that the bold was inserted by me); “Imagine peering down on the pile from above, and colouring it in according to its steepness. Where it is relatively flat and stable, colour it green; where steep and, in avalanche terms, ‘ready to go,’ colour it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton (fingers) of instability ran through the pile. The consequences of the next (insignificant) grain become fiendishly unpredictable and could trigger a response of any size whatsoever.” Thus “the greatest events may have no special or exceptional causes”.

This comes in sandy!

Translating this into the investment world, was the 2008 financial crash caused by the Lehman collapse, or was Lehman’s collapse caused by the 2008 financial crisis? The answer is obvious – the financial system was already troubled with numerous fingers of instability. The Lehman collapse was merely that sand grain. In today’s environment, we find ourselves with new fingers of instability. We have countries with unsustainably high debt (I.e. Greece), head-spinning amount of Quantitative Easing, negative rates by major central banks and political/social unrest in different parts of the globe. I have surely omitted a few. The fingers are there and could potentially be part of a future major collapse. It’s not so much about if, but when these major events will occur. The problem is however, we can’t identify the particular sand grain which will start the avalanche.

Therefore, as no one knows which grain of sand it will be, portfolios need to be managed by people who have shown a propensity to be nimble and act swiftly on quickly changing events. In our Multi-asset Growth strategies, we actively use downside protection, to protect your assets from any event that can weigh on your returns. Recently, our multi-asset team positioned themselves to circumnavigate the potential effects of the UK’s referendum on whether to remain in the EU. This is what we did.

Embrace the edge

The team had no specific insights into the referendum outcome, but their analysis indicated that markets were once more expensive. Also, the monitoring and risk analysis pointed to a risk/reward asymmetry as polling day approached. Markets were progressively pricing in significantly lower risk on growing conviction in a ‘Remain’ victory; for instance, the sterling/dollar exchange rate had recovered almost to 2015 levels. So if the ‘Remain’ campaign proved successful, the Team perceived very limited further upside – of perhaps 2%-3%, for both sterling and the UK equity market. Conversely, if there was an upset and the Brexit vote succeeded, they expected very significant downside for both sterling and equity markets. The risk/reward assessment therefore encouraged them to cut back risk quickly.

In our Multi-Asset Growth strategies:

  • We built an allocation to safe haven US Treasuries since the beginning of the year for our more cautious multi-asset growth strategies. Up to the day of the announcement (24th June), the benchmark 10-year Treasury yield declined 23% on a YTD basis. In fact, the yield dropped 11% alone over the 23rd and 24th of June period.
  • Very late on Thursday – hours before the voting was due to close – in some of our larger multi-asset portfolios, we bought additional equity-market protection on the S&P 500 Index, at the 2,100 level, at a time when the market was trading over 2,100 in anticipation of a ‘Remain’ win. This lowered our equity exposure.
  • Following the announcement of the Brexit vote, we saw a sharp fall in the UK equity market (-12%), followed by a swift rebound to the -2% level. This very brief window of opportunity allowed us to trim the UK equity exposure back further in several of our portfolios.

These changes resulted from thorough preparation, careful risk analysis and, last but not least, the skills of our in-house trading team. As a result, our multi-asset strategies recorded a performance that was only marginally negative on ‘Black Friday’ when equity markets generally recorded falls of 4-5%.

In conclusion, there is no faultless capability to predict the next major financial event. Therefore it is crucial to adopt actively managed downside protection in order to limit losses as and when the next sand pile collapses – as we do here at Russell Investments.