Markets Are Changing. Does the Portfolio Need to Change With Them?

Investors spend enormous amounts of time trying to understand markets: economic data, earnings, interest rates, geopolitical events, valuations, and countless other variables. But one of the most difficult questions is what to do when those conditions change.

Does higher volatility require action? Should exposure be reduced after a decline? Should a rally lead to more risk or less? And sometimes, is the best decision to do nothing at all?

A systematic approach attempts to answer these questions before they arise.

A Practical Example

Imagine stocks decline sharply over several days while volatility rises.

A discretionary investor immediately faces difficult questions. Is this the beginning of a larger decline? Should I sell? Is it already too late? Should I buy the dip?

A systematic portfolio approaches the same situation differently.

Suppose the portfolio has predetermined rules connecting position size to volatility. As volatility rises through established thresholds, the portfolio modifies certain exposures. If volatility continues higher, risk may be modified further. When conditions stabilize, exposure can gradually be managed according to the same rules.

The market might rebound immediately, making the changes in exposure appear unnecessary in hindsight. But the rule wasn't designed to predict the exact market bottom. It was designed to control how much risk the portfolio carries when uncertainty is elevated.

This illustrates a fundamental difference:

A discretionary process asks, “What happens next?”

A systematic process asks, “Given what is happening now, how much risk should the portfolio be taking?”

That shift, from prediction to process, is at the heart of systematic investing.

Removing Emotion from the Process

Fear, overconfidence, loss aversion, and recency bias can influence even experienced market participants. Behavioral-finance research has documented the role these biases can play in investment decisions.[1]

A systematic framework defines position sizing, risk limits, entry and exit criteria, and portfolio adjustments beforehand. The goal is not to eliminate uncertainty, but to reduce the influence of emotion when maintaining discipline may be most difficult.

Treating Volatility as Information

Volatility is typically viewed as risk, but it can also provide information about market uncertainty and expected price movement. Because volatility changes over time, systematic strategies can adjust exposure as predetermined risk measures change. When measured volatility rises, a strategy might modify exposure. When conditions normalize, it might alter exposure according to the same rules.

Research by Moreira and Muir found improved risk-adjusted results from systematically modifying exposure during periods of elevated volatility across several historical portfolios.[2] Subsequent research found these benefits were less consistent out-of-sample, reinforcing an important point: no quantitative rule works equally well in every environment.[3]

The objective is not to predict every market decline. It is to establish how much risk a portfolio should carry under different conditions.

Finding Information in Options Markets

Options provide another source of information for systematic investors.

Researchers have documented historical differences between option-implied volatility and the volatility subsequently realized by the S&P 500.[4] This relationship is commonly referred to as the volatility risk premium.

Options also exhibit skew, differences in implied volatility across strike prices. In equity markets, downside puts have historically often carried higher implied volatility, reflecting, in part, investor demand for protection against sharp market declines.[5]

A systematic framework can evaluate volatility, skew, time decay, position sizing, and other characteristics together. Instead of simply asking whether the market will rise or fall, the process can ask what compensation is available for accepting a particular risk and whether that risk fits within predetermined portfolio parameters.

Building Resilience Through Process

Markets will change. The more important question is whether every change requires a new investment decision.

A systematic framework establishes in advance when action is warranted, and, equally importantly, when it isn't.

No framework will make the correct decision every time. But investing may not require having a better prediction for tomorrow. It may be more important to have a repeatable process for determining how much risk to take today.

Stay Systematic, Stay Prepared, and Stay Ahead.

References

[1] Sharma, S. & Negi, V., Effect of Behavioural Biases on Investors' Decision Making: A Systematic Literature Review (2025).

[2] Moreira, A. & Muir, T., Volatility-Managed Portfolios, The Journal of Finance, Vol. 72, No. 4 (2017), pp. 1611–1644.

[3] Cederburg, S., O'Doherty, M., Wang, F. & Yan, X., On the Performance of Volatility-Managed Portfolios, Journal of Financial Economics, Vol. 138, No. 1 (2020), pp. 95–117.

[4] Bollerslev, T., Gibson, M. & Zhou, H., Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option-Implied and Realized Volatilities, Journal of Econometrics, Vol. 160, No. 1 (2011), pp. 235–245.

[5] Doran, J., Is There Information in the Volatility Skew?, Journal of Futures Markets, Vol. 27, No. 10 (2007), pp. 921–959.