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Investors' Focus on Risk Could Lead to Missing an Unexpected Rally

BNY Mellon Report Says Cost of Hedging Against Negative Developments Has Become Expensive

Investors appear overly focused on the downside risks to the markets and are not allocating sufficiently to take advantage of possible upside surprises, according to a white paper from BNY Mellon Asset Management's Investment Strategy and Solutions Group (ISSG).

The paper, A Radical Proposal for a Square Root Recovery: Don't Forget the Right Tail, focuses on the bearish view that has been incorporated into asset prices. It was written by Robert Jaeger, senior investment strategist for ISSG, and Stephen Kolano, investment analyst, ISSG.

The "square root recovery" in the paper's title refers to a jobless recovery, where employment growth chronically lags gross domestic product growth. In such a recovery, there is a gap between the potential output of the economy at full employment and the actual output at lower employment rates. A graph displaying this gap in the report forms a square root symbol for the years 2008 to 2011.

"The costs of hedging against negative news has become so expensive that many investors could find themselves in a situation where they are selling low and buying high," said Jaeger. "The issue is compounded when investors sell cheap assets that have the potential for significant appreciation if 2012 unfolds better than the consensus is predicting."

"Among the factors that could surprise on the upside would be a quicker-than-expected resolution to the European sovereign debt," said Kolano. "Already, we're seeing better economic indicators for a U.S. recovery than we saw just a few weeks ago. Also, China might not have a hard landing."

As the U.S. economy oscillates between slow growth and stalling, markets are likely to react dramatically to new information, both positive and negative, the report said. Upward movements would be lost opportunities for those not properly positioned, according to the white paper.

"We are not arguing that the economy will experience a prolonged square root recovery," said Jaeger. "The crucial point is that the square root scenario seems to have become the consensus scenario. That means that actions to sell growth/aggressive assets and buy income/defensive assets might lead to expensive mistakes."