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Princeton professor advises switching to safer assets at first sign of crisis
By Jonathan Kwok
24 August 2011
A visiting US expert on stock market behaviour has offered a grim prognosis of these volatile times.
Professor Yacine Ait-Sahalia, who specialises in finance and economics at
Princeton University, said that a sharp fall in the stock market often heralds more falls, so investors should head into safer assets at the first sign of trouble.
He said that this defies classical financial models, which stipulate that sharp movements in either direction - known in the academic world as ‘jumps’ - occur independently and rarely.
He added that while investors typically diversify their wealth across different asset classes in normal times, this approach is inadequate in times of crisis when prices plunge across the board.
Prof Ait-Sahalia was speaking on Monday at a forum at Shangri-La Hotel, organised by the Centre for Asset Management Research and Investments, which is a centre of the National University of Singapore Business School, in partnership with the Investment Management Association of Singapore.
Recent events seem to bear out Prof Ait-Sahalia’s findings that market falls often come in quick succession.
More than US$8 trillion (S$9.6 trillion) has been wiped off global stock markets over the past four weeks, and the rout has left shell-shocked investors drawing parallels to the darkest days of the financial crisis.
Often, a plunge in a financial market has been followed by similar bloodshed the next day or later that week.
‘In a crisis, a shock somewhere seems to increase the probability of successive shocks - not only in the affected asset class, but also in other asset classes,’ said Prof Ait-Sahalia.
He has developed a new model which incorporates such tendencies while allowing for the effects of shocks to dampen over time so markets can stabilise.
Prof Ait-Sahalia cited the example of the euro zone debt crisis. From 2000 to 2009, little happened, but in 2009 there were several downgrades on the debt of European countries. Last year, things escalated and currency and share markets plunged amid quickfire downgrades.
‘Once things start to become bad, they start to accelerate as well. You see that the countries tend to be downgraded at the same time, and the pace of the downgrades accelerates. There is often a self-feeding mechanism.’
So investors should quickly rebalance their portfolios at the first sign of trouble, because more plunges are likely.
In times of calm, investors should come up with a crisis plan, including setting thresholds for share movements before they will kick into action. Jumps are market movements that are very rare, said Prof Ait-Sahalia, and investors can look at historical charts to determine when to call a movement a jump.
‘When things go wrong...most asset classes decline together,’ he said.
He said there are some assets that benefit from a flight to quality, including gold, the Japanese yen, and German and US government bonds.
Rebalancing means quickly switching into these assets and going ‘short’ on risky assets such as shares, which essentially means taking bets that they will fall. These will help investors to ride out the crisis.
Prof Ait-Sahalia said investment portfolios tend to be optimised only for stable markets, and not for times of crisis.
But maintaining a crisis portfolio at all times is not a good idea, as asset prices tend to rise over time, he added. So, switching back to risk assets when markets stabilise is advisable.
He also spoke about the difference between upward and downward spikes in markets. Upward jumps happen more often, but are smaller in magnitude than plunges.