Investor Education

Understanding Volatility and Risk-Adjusted Returns

Henderson Rowe is disrupting the UK market by delivering institutional-quality investment solutions directly to private clients. In this investor education article, Thomas Simpson, an Investment Manager at Henderson Rowe, explains how private investors can adopt a more institutional approach to volatility. In particular, Mr. Simpson encourages investors to view volatility in the context of risk-adjusted returns. Individuals who cannot accept short-term volatility are unlikely to achieve long-term growth.

Introduction

Volatility – the degree to which an investment rises and falls over a given time period – is a persistent fear for UK investors. Private clients often respond to volatility by making impulsive decisions to buy into or stay out of certain markets without considering how such moves will impact their long-term portfolio outcome. This fundamental investing mistake is, unfortunately, encouraged by a UK financial market that constantly pushes new products with a fixation on recent performance. However, we know from experience that reactionary behaviour is almost always to the long-term financial detriment of investors.

But there is good news: it’s easy for informed private investors to avoid this basic error. That is because “volatility” is neither scary nor new. In fact, institutional investors have successfully managed volatility in their portfolios for decades, and private investors can do the same if they are equipped with the same knowledge of how risk affects their investments. Armed with better information, private investors can adopt a sensible approach to volatility that will help them realize the long-term benefits of a suitably diversified portfolio.

Volatility is Nothing New

Given the UK’s current political gridlock and other regional concerns, there is a sense among private investors that volatility is higher today than in the past. But when pressed, most cannot recall a time they considered capital markets to have low volatility. Their recollections are correct.

The reason for this disconnect is that many private investors still think of “volatility” exclusively in terms of political or market uncertainty. As a result, when an investment declines in sync with their subjectively negative macroeconomic sentiment, they become afraid. This is not a productive way to think about volatility. Instead of imagining volatility as part of an emotional narrative of current events investors should view volatility as a simple numerical measure of portfolio risk. Once they understand volatility in this more objective light, they will see that investing in the UK is the same as it ever was. There has never been such thing as a risk-free investment. That was true 25 years ago, and it remains true today.

The False Promise of Volatility-Free Returns

Even when clients begin understanding volatility as a measurement of risk, they still crave an investment that appreciates ever upwards, with no downward volatility. Surprisingly, those investments do exist – but they come with a major caveat.

On the one hand, there are investments that have climbed inexorably upward without volatility. On the other hand, all such investments were later discovered to be Ponzi schemes. The most (in)famous of these was the Madoff Fund, which climbed 1% per month for years on end, until it collapsed almost overnight and investors lost everything. More recently, the cryptocurrency token Bitconnect soared without decline to $463 – before plummeting to just $0.40 in less than a year(1).

There are many other examples, but this is the important lesson: an investment that generates relentlessly positive returns without volatility is probably a Ponzi scheme. This kind of investment performance – extraordinary returns with no corresponding risk – is simply not how capital markets work. So, for those asset owners who cannot tolerate investments with downward volatility, either don’t invest or be hyper-vigilant about false promises.

Volatility as a Measure of Risk … and Potential Rewards

Once investors begin to treat volatility dispassionately as a measure of risk, the question simply becomes how much risk the investor can tolerate – and in exchange for what potential upside. To weigh such trade-offs, investors should understand that volatility captures not just the risk of extreme loss, but also the everyday ups and downs of an asset’s price.

Indeed, there are degrees of risk, and volatility offers a means of assessing just how bumpy the ride might be for an investor in a particular asset.

Of course, one need not take on high levels of risk to participate in the market, just as investors with a greater capacity for bearing volatility are free to take a bit more risk in a reach for higher returns. Most portfolios are constructed specifically to take on more or less risk depending on investors’ financial objectives, personal circumstances and risk tolerance. Rather than avoid markets altogether, investors should adjust their portfolios to take on a suitable level of risk. This is important because, despite the volatility of markets, investors who failed to invest in equities have missed out during a bull market in which the S&P 500 returned in excess of 300%(2).

That said, while investors should not shy away from volatility, neither should they accept unreasonable or unsuitable amounts of risk. To the contrary, they should only take on downside risk that is reasonable in relation to potential upside. Stated differently, when investors consider returns, they should consider them in relation to their risk. They should require portfolios with high volatility to have high potential returns, and expect low-risk portfolios to yield less impressive performance. This concept of “risk-adjusted return” is well-understood by institutions, but it is still unfamiliar to many private investors.

Conclusion

Outperforming the market is a zero-sum game with winners and losers. Historically, the winners are those who deeply understand and can tolerate short-term volatility on the path to long-term gains – primarily institutions. The losers have been those who react to short-term volatility, locking in losses or buying over-priced assets – primarily individuals. Ultimately, those who panic in the face of volatility create opportunities for investors with the knowledge and discipline to stay the course.

References

  1. https://bitconnect.io, archived 2019
  2. https://wsj.com, archived 2019
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