Investors need to brace for market volatility

Didier Saint Georges

Didier Saint Georges

A decade on from the 2008 financial crisis, we can safely conclude that we escaped the worst.

Central bankers have started mothballing the arsenal of unconventional tools they deployed to save the financial system, and this change of regime under way is delicate for investors to negotiate effectively.

But, more importantly, it is of crucial significance for risk management.

As is widely understood today, such extraordinary central bank intervention amounted to a form of “financial repression” by forcing down interest rates and, as a result, artificially pumping up financial asset prices. That was then.

But now, investors have to resume the tough job of estimating the true value of stocks and bonds.

They also have to brace themselves for greater market volatility.

Over the years, regular, massive, and predictable central bank intervention in financial markets played a stabilising role.

Today, the uncertainty inherent in investment flows, in forecasts by economists and financial analysts, and in investor perceptions, is back in town – bringing with it a higher level of average market volatility. 

But that is not really the key issue. As central banks bow out, we need, above all, to prepare for the improbable once again. 

Such outlandish scenarios happen to be an intrinsic part of financial market history. And the problem today is that the central banks are no longer in a position to counter them.

As statisticians explain, market events do not follow a “normal” distribution curve, which would allow us to rule out any events with a statistically negligible chance of occurring.

They rather follow much the same distribution curve as natural disasters (earthquakes, tidal waves, etc) or as curves for the distribution of wealth among individuals.

That means that historical data is of little help in determining the probability of extreme events. For example, what matters when you live in a seismically active area are unusual volcanic eruptions, not the pattern of countless minor tremors.

By the same token, financial markets do not follow a normal statistical distribution. 

As many savers learned the hard way in 2008, volatility is not the long-term risk; financial ruin is.

To borrow from the jargon of statisticians, it is not the many statistical events distributed around the mean that count, but the extreme ends of the distribution curve, which give rise to what is known as “tail risk”.

However unlikely they are to occur, those extreme events change the whole game when they do. 

The all-powerful central banks addressed just that kind of risk during the crisis via the posture summed up in the famous words spoken by European Central Bank (ECB) president Mario Draghi (pictured) in 2012: “The ECB is ready to do whatever it takes.”

He even went on to add: “And believe me, it will be enough.”