Looking at public equity market charts for the year so far, many form a V-shape.

In these V-shaped situations of rapid decline followed almost immediately by a strong recovery, two very different investment scenarios can prove beneficial, according to a recent blog by Reka Janosik, vice-president at MSCI Research and Thomas Verbraken, the organization’s executive director. Investors can benefit from having a very low risk tolerance, which would lead them to exit a plummeting market in the earlier stages of a downturn. By contrast, investors can also profit from doing nothing, if they have the liquidity and governance capabilities to ride out the storm.

Looking at the MSCI’s USA index year-to-date, results are essentially flat as of Aug. 4, 2020, meaning investors who simply waited the market crisis out without making portfolio adjustments haven’t taken much of a hit. “In times of heightened volatility, however, tactical shifts are often put in place to protect against further drawdowns,” the blog said. “While such measures can be effective in dampening portfolio losses, they may also have an impact on long-term returns, particularly in the case of a sharp V-shaped recovery such as the one we have seen in the past months. Appreciating the tradeoff between limiting drawdowns and hampering longer-term performance can help investors make more informed decisions.”

So while portfolios that implement risk limitations can mitigate the sudden potential losses of a dramatic market crash, they won’t necessarily outperform in the long term. The MSCI demonstrated this with a hypothetical portfolio invested in U.S. equities with a volatility-based risk limit of 20 per cent. Such a portfolio would have seen a 17.7 per cent drop during the worst phase of the coronavirus crash, whereas the market dropped by 30.5 per cent at the bottom of the crisis. However, because of the quick turnaround the market made, the portfolio using the risk limit would have underperformed the market by 7.7 per cent on a year-to-date basis.

Overall, the MSCI found either a very strict risk limit or a limit that was so lax it didn’t kick in, would have been the sweet spots for investors. “Intermediate threshold values, which reduced exposure too late and missed out on a large part of the rebound, led to the largest underperformance,” the blog said. “In such scenarios of V-shaped rebounds that coincide with high-volatility regimes, investors would have benefited from either reacting quickly to rising volatility and getting out early or having the liquidity and governance in place to ride it out.”