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Enhancing decision making through cyclicality and dynamic asset allocation

23 October 2017

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Hens Steehouwer discusses how investors can use their understanding of cyclicality to enhance investment decision making.

When I think back to my university education in the 90's, the lectures that really stood out for me were those on time-series analysis and understanding how economies and financial markets move up and down.

As a student, keen to learn the ways and wherefores of investing, it was almost an epiphany moment – the realisation that if, as an investor, I could better understand how markets fluctuate, I would be far more equipped to make better investment decisions.

For the past two decades, I have stood by that learning and spent most of my career on building, applying and improving models of economies and financial markets.

Education is cyclical

Fast forward to 2017 and I've just returned from an INQUIRE Europe Conference in Switzerland. There, one of the interesting papers that was presented concluded that the vast majority of so called 'anomalies' that have been reported in the literature, actually cannot be replicated.

This finding is close to my heart, as it confirms what I have learned over the years: when trying to understand how markets fluctuate, it is essential to apply a sound and strict set of methodologies and techniques to prevent finding unreliable or spurious results.

Such a methodology is also needed to distinguish between the two views that I was presented with as a student. Firstly, that markets and economies move in completely unpredictable ways, that they are fully random without any underlying structure. The second is that there actually is some underlying structure to be found, while recognizing that the world remains a highly uncertain place. So, education and focus on topics at a given time can be cyclical.

Cyclicality as a stylized fact

My personal conclusion, fortunately supported by many others, is that the second view of the world is the most realistic one: if one looks carefully there is indeed some structure to be found.

Such structures are typically referred to as 'stylized facts'. Stylized facts are characterisations of how markets and economies move up and down which most people agree upon to describe reality.

One important type of stylized fact that is found, is cyclicality. Cyclicality comes in different forms, the simplest example of which is the change in seasons from Spring, Summer, Autumn to Winter, 'seasonality'. This is a mechanism which everyone is familiar with that repeats itself and impacts the economy as the seasons change.

Business cycles – a more complex example – are about medium term alternating patterns in overall economic activity, driven by structural and behavioural forces. But when thinking about cyclicality, a word of warning is in place – while cyclicality may indicate an average way of how markets and economies tend to fluctuate, it does not offer a crystal ball and also under the cyclicality assumption the future is still highly uncertain.

Stronger together

How can we use our understanding of cyclicality to enhance investment decision making? Well, if conditions change over time and contain some information about how the future might unfold, than a logical consequence is to start thinking about how this information could be used for dynamically changing an asset allocation over time.

Models that manage to capture cyclicality in a realistic way can provide relevant information to those with an asset allocation expertise.

The (almost) epiphany moment at university has served me well (so far), but if we are able to build better dynamic asset allocation strategies by using cyclicality, investors will make even better decisions and people will be more likely to achieve their goals. And for any investor, that is the ultimate aim.

Hens Steehouwer, Head of Research at Ortec Finance