- On 5 February the Dow Jones suffered the largest one-day fall in points in its history.
- Several products that bet on low volatility collapsed when markets stopped being stable.
- It is wise to understand how each product behaves in an adverse scenario, not only in a favourable one, before buying it.
On 5 February 2018 the Dow Jones suffered the largest one-day fall in points in its history. The blow shook Wall Street. In addition, several products that bet on low volatility collapsed, a technical detail that explains why the move was so abrupt for those who held them. Episodes of this kind are hard to anticipate: what looked like a quiet series of sessions turned, in a single day, into a move that no calendar had announced.
The episode mattered because it came after a period of calm in the markets. Those who had grown used to quiet rises found, from one day to the next, that things could move the other way with surprising speed. For business owners and families with investments, it was a good occasion to check what is really in their portfolio. Many people discover the risk of what they own only after it has materialised, and a sharp fall, even a temporary one, is an involuntary test of how well the investment had been thought through.
Points and percentages
A record fall in points is striking, but it is worth remembering that the index stood at very high levels and that the same number of points weighs less in percentage terms when the index is high. Even so, the abruptness of the move shook markets that had been very calm for some time.
That is why it helps to read headlines with some distance. A record in points says little about the real size of a fall unless it is compared with the level of the index. What it does reveal is the change of mood: when markets have gone a long time without a scare, any scare feels like a rupture, even if in historical perspective it may not be one. The prudent question is what share of one’s wealth was affected, not how many points the index lost, which is the figure that really changes a family’s decisions.
Betting on calm
Volatility measures how much prices fluctuate. Some financial products were designed to make money while markets stayed stable, and they suffered when markets suddenly stopped being so. It is a general warning: a product that works well in calm times can behave very differently under stress.
Products of this kind are often attractive precisely because they perform well for a long time, until the environment changes. The risk is hidden in their design and is not always visible in past results. A complicated strategy can behave simply while all goes well and very differently when something fails, and that is when the investor discovers what was held. Complexity is not bad in itself, but it demands an explanation to match, and whoever offers it should be able to give it clearly.
Understanding what you hold
For investors, the useful question is whether they understand how each product behaves in an adverse scenario, not only in a favourable one. Reviewing the make-up of the portfolio and the risks of each piece with an adviser helps avoid discovering them at the worst moment. It is a conversation worth having in calm times, when one can ask without pressure and compare alternatives serenely.
A practical rule is not to buy anything one cannot explain in one’s own words: what it does, how it makes money, when it loses and how much it could lose at most. If the answer is not clear, prudence suggests asking for more information or declining. And it is worth going over the whole portfolio from time to time, to see whether it has accumulated similar risks without anyone having decided so. It also avoids the portfolio resembling a single bet more than its owner imagined.
A complex product is only suitable if you understand what happens when things go wrong.
This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.
