To describe the financial markets as strange is probably a huge understatement. Where in the past there was a sense of sanity, today each morning brings only apprehensions about volatility. Most of us have no clue what is in store for the markets each day beyond the little gleaned off the daily performances of the Asian and European markets and perhaps the expectation of a roller-coaster ride.

One way of describing the recent phenomenon is that our systems of information processing and the formation of rational expectations for earnings per share, return on equity, GDP, etc., have broken down. It is nightmarish to manage money under these circumstances.

One of the better indicators of the level of market uncertainty and volatility is the VIX index. Figure 1 graphically illustrates the uncertainty levels that all money managers face in today's financial markets.

The VIX Index has looked like a forward-moving tsunami since August, when the rating for U.S. Treasurys was cut and the European debt crisis raged. Since then, volatility has nearly doubled.

Figure 2 shows the ravages of volatility in the last five years, especially since 2008 when Lehman Brothers failed, while Figure 3 shows the history of the VIX since its introduction in 1990. What is interesting-and maybe somewhat ominous-is that these problems may just be starting and not ending.

The unprecedented volatility has created markets that are hard to explain in everyday terms. When the U.S. Treasury rating was cut, for instance, Treasurys actually rose in price! How strange is that? A similar phenomenon was observed recently in Italy when that country's sovereign ratings were cut by three notches-and yet the markets shrugged it off! Hundreds of billions of dollars, if not a trillion or more, have oddly been pouring into the bond markets-record sales for ten-year T-notes at yields around 2%.

What kind of investor is willing to lock in such low rates for ten years, in an environment where bond yields have nowhere to go but up and prices down? Such an investor can only buy high, sell low or hold for ten years and earn little more than 2%.

fig 1, 2


There's another reason for concern: the record holdings of cash by mutual funds and other pooled accounts reported by the Investment Company Institute. The only rational explanation for such behavior is the staggering uncertainty and fear of loss in this economy.

The situation is no less confusing from the street-level money manager's view. Figure 4 tracks the relationship between the VIX Index and the S&P Index.

This is a very unnerving picture when looked at closely. On the surface, it's clear that domestic equity markets (represented by the S&P) are negatively correlated with volatility, and an increase in volatility heralds a market downturn. More worrisome is the inference that equities go down every time volatility (risk) increases. The markets are basically saying, then, that taking more risk today should lead to lower returns. That idea flies in the face of financial theory; we are supposed to accept speculative risks only when we expect to be justly compensated by a healthy risk premium. In reality, the market is showing the opposite.

This is the problem at the heart of the financial crisis. Our understanding of how financial markets work and how we construct portfolios for clients is being shaken to the core. We need to find ways to serve our clients in a competent and fiduciary-like manner. But that means money managers might need to depart from some of the tools and techniques they have used before. They cannot blindly adhere to the doctrines of modern portfolio theory and the efficient market hypothesis.

Instead, they might have to develop techniques and strategies better suited for today's global economic environment. Of course, clients still need to grow capital or else secure retirement income. But today, these goals have been stymied by market losses. So now is the time to rely on age-old heuristic techniques of money management, such as the life cycle hypothesis and modern methods of loss management that use simple derivative securities.

The Life Cycle Hypothesis Of Investments

This approach simply assumes that we can absorb more losses when we are younger and our need for capital growth is stronger. The portfolios of such clients should include aggressive investments such as small caps, emerging markets, junk bonds, commodities and precious metals. Of course, such a strategy is matched by another heuristic approach-a buy-and-hold strategy-since aggressive investments need enough time to have a chance to earn their long-term expected mean returns.

As people age, their tolerance for losing hard-earned wealth declines, hence they start moving out of riskier assets into safer ones. Such investors are more into fixed-income products; their equity positions are generally in global large caps and blue chips meant to buy and hold.

As people approach retirement and finally stop working, their loss tolerance is so low that they prefer mainly to be in fixed income and other products that produce a safe fixed-annuity-like income through their retirement years. Typically in the life cycle approach, the secure investments (fixed income and annuities) should provide distributive income while riskier assets such as equities can either be liquidated for emergencies or passed on to the beneficiaries of a client's estate.

As an academic, I find it hard to believe that advisors have chosen to follow modern portfolio theory and other rational (and very fancy) models over such simple approaches that can be of so much more value to clients, simply because no academic and theoretical support exists for such approaches. 

Heuristic Modern Portfolios

Heuristic models have no limits on possible portfolio structures, since there is no reason to limit the number of portfolios for the efficient frontier. Why? The efficient frontier is already an abstraction: Future correlations are not possible to predict with any reliability, even according to the efficient market hypothesis of the rational school.

Heuristic portfolios instead rest on client characteristics such as loss tolerance and client lifestyle financial needs. Not only are such portfolios based on horse sense, but they can also be creative and satisfying to build. But accepting them requires some basic reasoning and analysis and generally shutting down the mind set of modern portfolio theory.

The chief problem in portfolio construction these days is super-heightened uncertainty and volatility. That means all portfolios must have some mechanism of volatility containment. Assume that a portfolio for a very aggressive client is being constructed. You can begin building the portfolio starting with a healthy dollop of high risk/return securities-say a 60% allocation that includes small caps, emerging markets, junk bonds, etc. Since volatility is also a traded investment, you can add to the portfolio an investment in the VIX as a hedge against wealth loss in equity. We can discuss the allocation proportions later.

Observe Figure 5, which shows the monthly risk-return statistics for investments in the S&P 500 and the VIX index.

Figures 3, 4, 5 


The story in these numbers is chilling. First, investing in risk, as measured by the VIX, has had a better payoff than investing in equity returns. Second, positive equity returns in the '90s turned negative in the next decade even as the market risk increased. So in the last decade, equity investors assumed more risk and earned negative returns on their investments. On the other hand, the strong negative correlation between the VIX and the S&P (which can be seen in the tables below) suggests that in a stabilizing global economy a portfolio containing both securities would see decreases in the VIX position and increases in the value of the equity positions. A decrease in global stability would cause the opposite. 

Gold Punch

The next ingredient in such an aggressive portfolio must be gold. Since equity return performances have been abysmal for quite some time, a portfolio of equities cannot be considered aggressive anymore by investors seeking high returns for capital growth. But gold has displayed a stellar return performance since the '70s. Figure 6 shows the sizzling performance during the last seven years.

These returns are the kind that aggressive equity investors seek. To determine the allocation among these three assets, investors must analyze their correlation structures (see the table below). On the surface, the relationship between the VIX and the other two measures seems ambiguous (the correlation with both is about 15.8%) and even insignificant for the period from 1990 to 2011. During the same period, the correlation between gold and the S&P was, as expected, negative (at -23%) but again, insignificantly so. It would seem futile to try to structure a portfolio of these components since there would be very little diversification. But it would also be bad to dismiss this portfolio out of hand, because the same period saw the formation and crash of two significant bubbles (the dot-com bubble in 2000 and the real estate bubble in 2007) that influence the results.

Figures 6, 7 


Thus it would be useful to examine the correlations around these macroeconomic crises and the special circumstances surrounding them, since they bear much resemblance to the present and might forebode a similar future.

If we construct four-year windows around March 2000 and December 2007 (the bubble peaks), then a very different picture emerges. Figure 7 shows the correlation of these three investment options during these time periods.

The dot-com crash of 2000 was not as bad as the 2008 financial crisis. The latter embroiled the entire global financial industry, not just an isolated U.S. tech industry. Meanwhile, at the turn of the millennium, the dollar was still an attractive investment and reserve currency. These were all good reasons that the relationships among gold, stocks and volatility were not meaningful over the longer time period.

The story for the 2008 crisis, however, is completely different, and the super-high correlations are indeed very telling. 

Loss Management 

So far, we have a very aggressive three-asset portfolio. If the global economic uncertainty increases, gold and the VIX would produce positive returns while equities would languish. If we move to a more stable environment, however, the equity positions would pay off. To further increase the riskiness of the portfolio, we can add a slice of currency, placing a bet on the short dollar (ETF: UDN). If global stability increases, we assume the dollar will continue sliding and hence help the portfolio. So one arbitrary allocation would be 60% to equities, 20% to gold, 15% to the VIX and 5% to the UDN. To increase risk (for return) further, we could reallocate more toward gold. It's that simple.

This is the skeleton of an aggressive portfolio, but only the die-hard, risk-loving investor would opt for it. Fortunately, the underlying heuristic technique allows us to easily adapt this allocation to less-risky versions for less aggressive investors, perhaps older ones. To decrease portfolio risk, we could decrease the allocations to equities, the VIX and gold and replace them with investments in asset classes such as global fixed income, commodities, real estate and currencies. That way, the portfolio would start to benefit from the usual diversification techniques that reduce risk. ETFs would allow for very easy portfolio rebalancing, when necessary.

What our recent experience in the 2008 financial crisis has taught us is that while diversification is beneficial to portfolios during normal times, it is not enough to protect portfolios from significant capital losses during global macroeconomic turmoil. In such situations, an even better alternative to ETF investments is to buy one-year call options on the ETFs. This portfolio would contain an allocation of about 90% to cash-like securities (TIPS, money markets, etc.) and the remainder would go into one-year call options on diversified asset class global ETFs.

This approach allows us to reduce the amount of money in the speculative securities without giving up their upside potential, and also protects us against catastrophic losses (the maximum loss is limited to the 10% call premiums minus what's earned from the money market earnings). If the markets do well, we realize portfolio gains (minus the individual asset class option premium costs). If the market dives, we contain our losses. With the current volatility, such a portfolio is hard for any investor to resist when the alternatives threaten the huge loss of hard-earned wealth. Again, the exact allocation is subjective and based on the client. But that is how it should be. Otherwise, it would be based on a theory that makes assumptions so tall the shade is scary.

The aggressive portfolios can also be further tuned down by simpler methods. Note that the aggressive portfolio is completely exposed to the ravages of an economic downturn. If it happened, most of the securities would lose a lot of value. To blunt the loss of an aggressive portfolio, an investor must buy puts on asset indexes. The number of puts to buy (using the asset value in dollars covered divided by 100 times the strike price) would offer full protection from equity losses. If the insurance (put) premiums seem too expensive, an investor should buy a lesser number of contracts (underinsure) or buy out-of-the-money puts to reduce his or her premium. The latter method is very similar to deciding what your deductible should be on your auto insurance. Call options behave similarly, so investors can use similar features. Full protection is expensive, but underinsuring or using deductibles can help reduce the premium.

Now, finally, we have a heuristic portfolio that can compete with the most conservative modern portfolio theory portfolios-but without ever needing to use a black box contraption. And yes, bye bye volatility, too.

Somnath Basu is a professor of finance at California Lutheran University and the director of its California Institute of Finance. Dr. Basu also serves as a professor of the Helsinki School of Economics executive MBA program. He's involved with financial planning organizations including the National Endowment for Financial Education, the CFP Board of Standards, the International CFP Board and the Financial Planning Association.