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Smooth Seas Do Not Make Skillful Sailors

July 11, 2017 | Multi-Asset

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The global market's ongoing low volatility should be unsettling for investors. After all, as the old proverb goes, “Smooth seas do not make skillful sailors.”

This low volatility is being driven by two factors: 1) Availability bias, and 2) Regulatory behavior.

What is Availability Bias?

Availability bias is when investors' perceptions of what's happening in the markets and their anticipation of future events are bounded by their past market experience. That past experience seems to frame the size of losses about which market participants believe they ought to be concerned. As a result, they're lulled by minor risks and only guard against minor risks as they progress. A consequence of this bias is that investors are ill-prepared for the occasional major event that previous history did not contain.

For the market in general, investing is backward looking. And that backward-looking nature inherently creates availability bias, which in turn informs investors' perceptions about the future. That should be no surprise to anybody. If you want to anticipate what flows will be into a certain sector, market, or investment strategy, just look at the most recent three-year performance metrics.

In this environment, we see a lot of investment strategies that employ a “rearview mirror” approach to investing and that have no flexibility to adapt to major market changes. And, to further complicate, we have not seen a major event for quite some time—since the third quarter of 2011 when the European debt crisis hit.

We've created an environment where we have a decreased frequency of loss events. At the same time, this environment is increasing the potential for a major loss event.

Regulations Reducing Loss Events

On top of availability bias, we have a regulatory and policy environment, including central bank ultra-easy money policies, Dodd-Frank, Basel III capital requirement standards, and Solvency II insurance legislation in the European Union that decreases the frequency of loss events.

Think of these regulations in terms of an avalanche analogy that we use frequently.

Prior to winter in parts of the United States and Canada, forest rangers will install wire slat fences in areas of high avalanche risk. The purpose of these fences is to hold snow in place in order to prevent an avalanche from starting. But by doing so, these fences prevent small, “safer” avalanches and instead increase the risk that a larger, more dangerous avalanche occurs should the fences fail to do their job.

Regulation can be thought of in a similar way—when regulation is designed to withhold the possibility of any market event, be it big or small, the risk and size of an extreme event increases.

And that's what we have today. We've created an environment—for an extended period—where we have a decreased frequency of loss events, an accumulation risk of a major event, and a bias that does not contain the wisdom of navigating any such event. So, market volatility is low. At the same time, this environment is increasing the potential for a major loss event.