The Highway Code is full of great advice, designed to keep us safe on the roads, what is less well-known is that it also contains some very helpful advice on investment strategy, take for example sub-paragraph 146 of General Rules, Techniques and Advice for all drivers :
Adapt your driving to the appropriate type and condition of road you are on.
Despite the simplicity and common-sense nature of this short sentence, it’s an incredibly insightful philosophy to apply when thinking about investments, after all, market conditions can change substantially and quickly, so shouldn’t all investors have a strategy in place to react to this ?
One such approach is an equity benchmark that varies the exposure to equities depending on the underlying markets conditions, as measured by the volatility of the market. We’ve previously written in detail on this idea here and it’s an idea that has gained more and more traction in the mainstream investment community, with Schroders in particular writing several good pieces on the benefits of such an approach, and an article appearing on the front page of the Actuary magazine.
Also, check out our video on the subject.
Getting back to the highway code, there is some further great advice in Control of the Vehicle sub paragraphs 117-119
In normal circumstances. The safest way to brake is to do so early and lightly. Brake more firmly as you begin to stop. Ease the pressure off just before the vehicle comes to rest to avoid a jerky stop.
In an emergency. Brake immediately. Try to avoid braking so harshly that you lock your wheels. Locked wheels can lead to loss of control.
Skids. Skidding is usually caused by the driver braking, accelerating or steering too harshly or driving too fast for the road conditions. If skidding occurs, remove the cause by releasing the brake pedal fully or easing off the accelerator. Turn the steering wheel in the direction of the skid. For example, if the rear of the vehicle skids to the right, steer immediately to the right to recover.
Again, while these principles are essential for safety on the road, the same is true of their application to financial markets. Braking (or reducing one’s financial exposures) sharply and late in response to a change in conditions is generally something to be avoided, a much better approach is to brake lightly and in plenty of time – or in the case of financial markets to carefully reduce one’s exposures in a systematic way as conditions (or volatility) change. Here is an illustration of how this would have worked in practice, as shown in the chart below, the declining pink area shows the steady braking approach in action well in advance of the Lehman crisis in October 2008.
By braking lightly and early when driving, we aren’t expecting a crash, just taking appropriate risk management precautions. The same is true of controlling risk when investing – we aren’t trying to predict a market crash every time we reduce our exposures, simply taking a sensible precaution in reducing our exposures as risk has risen.
In some aspects of life -such as driving – we naturally have well-developed and effective risk management mechanisms, its time we started applying these more in mainstream investing.