How to invest in times of financial turbulence: the foolproof formula

While it can be difficult to remain calm while savings are affected, history shows that markets tend to recover, and making impulsive decisions is rarely a good idea. It is wiser to wait for the storm to pass and for prices to resume their long-term upward trend.

Through this approach, which seeks to avoid emotionally driven selling after a significant dropis valid, although it is also convenient for investment platforms that charge commissions based on the time that clients remain in the market. However, The idea that the best response to volatility is to do nothing may seem unsatisfying..

After all, markets often overreact, and price fluctuations can be the result of technical factors rather than fundamental changes in the economy. But that doesn’t mean there isn’t valuable information amid the volatility.

Strategies to deal with market volatility

So how should we respond to the recent turbulence in the markets? A good starting point is to review the portfolio allocation. If you follow the classic strategy of holding andWith 60% of your savings in stocks and 40% in bonds, recent volatility has likely thrown that balance out of whack..

With stock prices falling and bond prices rising, the portfolio’s proportion may have shifted to something closer to a 56/44. While this may seem insignificant, restoring balance is important to maintaining a coherent long-term strategy. Selling bonds that have risen in price to buy stocks that have fallen can be a good opportunity to capitalize on the current turbulence.

However, this type of opportunistic rebalancing is easier said than done. There is always the temptation to wait a little longer, in case the stock falls further and get a better price. But trying to get the timing right It is a trap that often leads to lost opportunities.Therefore, it is best to take a regular approach to rebalancing, such as at the end of each quarter or each month, regardless of market conditions.

For the more analytical, there is the option of digging into the numbers and taking advantage of the information revealed by market volatility. When bond prices rise, their yield falls, while when the stock market plummets, the expected return on stocks increases.

Merton’s formula

This can make stocks look more attractive, but also riskier. This is where the “Merton formula“, which suggests how to optimize the division of a portfolio between stocks and bonds based on the investor’s expected return, volatility, and risk aversion. Adjusting portfolio allocations in response to a crisis can help maintain a balance between risk and reward.

However, it is important to remember that stepping in the middle of a storm can be risky. Professional investors can move quickly between bonds and stocks, but retail investors often face delays that can cost them dearly if prices change unfavorably. Also, making too many changes to the portfolio can lead to selling assets that still have growth potential, resulting in the loss of potential gains.

Therefore, any change in portfolio allocation should be the result of a plan drawn up in calm times, not an impulsive reaction in moments of panic. While Merton’s formula can offer valuable guidance, it is unwise to adopt it under pressure. The key is to have a predefined strategy that allows you to react in an informed and unhurried manner.

Ultimately, investors should not completely ignore market madness, but they should have a solid, well-thought-out plan to deal with it. Being vigilant and acting cautiously, without losing composure, is the true formula for successfully navigating turbulent times.

Merton’s formula “Merton formula” has several important implications, especially in risk management and the valuation of financial instruments that depend on the solvency of companies. For example:

1. Valuation of Corporate Bonds:

• Determination of Bond PriceInvestors can use Merton’s formula to estimate the fair price of a corporate bond by considering the probability that the company will default on its payments. If the probability of bankruptcy is high, the price of the bond will be lower, reflecting a higher risk to investors.
• Credit SpreadMerton helps explain the credit spread, the difference between the yield on a corporate bond and a risk-free bond (such as a Treasury bond). This spread reflects the additional risk that investors take on when lending money to a company.

2. Credit Risk Management:

• Estimating the Probability of DefaultPortfolio managers can use Merton’s formula to estimate the probability that a company will default on its obligations. This allows them to adjust their portfolios to avoid potential losses in the event of bankruptcy.
• Asset SelectionBy identifying companies with a low risk of bankruptcy, investors can optimize their asset selection, choosing investments with a favorable risk-reward profile.

3. Valuation of Credit Derivatives:

• Credit Default Swaps (CDS)Merton is essential for pricing CDS, which are insurance against default risk. Investors can use these derivatives to protect against potential defaults in their bond portfolios.
• Credit Risk Based Instruments: In addition to CDS, there are other derivatives and complex financial structures that depend on the credit risk of companies. The Merton formula helps to value these instruments and understand how credit risk affects their performance.

4. Portfolio Analysis:

• DiversificationInvestors can apply the Merton model to assess how the credit risk of different companies affects the diversification of their portfolio. Investing in a set of companies with low bankruptcy risks can reduce the overall volatility of the portfolio.
• Performance OptimizationBy quantifying the risk of failure of each investment, investors can allocate capital more efficiently, seeking a balance between risk and return.