There are also two Transitional Market States. A Transitional environment is in the process of shifting from one extreme environment to another, similar to the transition between summer and winter. One transitional Market State environment begins as volatility is increasing from a low level. The increase in volatility may be signaling a potential high-risk market ahead, meaning a bearish Market State. The other transitional Market State begins when a clear decrease in volatility is established following a previously emotional highly volatile period.
Lastly, the seasons do not go from winter to summer overnight and markets do not shift from a bullish to a bearish environment based on a couple spikes in volatility. Both require some time, and both will go through a process to shift from one extreme to the other.
Hortz: What significance does a Market State have on a portfolio and the portfolio management process?
Hardin: Markets are liquid. The liquidity in markets is created by investors’ real time buying and selling. Securities prices will fluctuate based on the law (not the theory or hypothesis) of Supply and Demand. The shifts between supply and demand can be stable and orderly or highly emotional or anything in between. As a result, a fixed portfolio’s volatility will vary within a wide range. For example, when a portfolio experiences an increase in volatility, then we know that the correlations among the portfolio’s securities are increasing, and the portfolio is experiencing a decline in the benefit of diversification.
In other words, the combination of diversified securities that was producing an efficient portfolio in the past, is now becoming less efficient as the environment begins to change. Logically, how can a fixed, stagnant portfolio always be efficient when the markets are dynamic? The only way to maintain portfolio efficiency when markets begin to shift from one environment to another is to take advantage of the liquidity available and begin to adapt the holdings to match the new realities of the now existing market environment.
Hortz: How would one go about “adapting” a portfolio?
Hardin: We've developed an adaptive portfolio management methodology. We call it the Canterbury Portfolio Thermostat. Our adaptive portfolio management process acts like a thermostat, in that it can identify the current market environment and adapt the portfolio’s holdings to match and move in concert with the changing environment.
The efficient portfolio is a moving target. The holdings of an efficient portfolio, during a bull market, will be different from the holdings of an efficient portfolio during a bear market. Therefore, risk management should not be based on predictions of the future, but should be adaptive and performed on an ongoing basis. There's so much better risk control for the portfolio in having this real-time dimension added.
Hortz: What advice can you give advisors on what best to focus on in this evolving investment environment?
Hardin: Based on our experience, the most important role of an investment manager is to manage the client’s expectations and emotional risk. It is our job to make good decisions and provide acceptable results regardless of the variable market environments. You need to be able to demonstrate that your focus is to manage for volatility risk and market corrections. If you can do that, then the clients are going to do well over the long run and be less anxious.