Is volatility risk?
After a long period without significant market upheavals, investors might be forgiven for pushing volatility down their list of concerns. We think that would be a mistake.
After a long period without significant market upheavals, investors might be forgiven for pushing volatility down their list of concerns. We think that would be a mistake.Low volatility can sometimes represent the calm before the storm. But even when the storm hits, we don’t think volatility is necessarily something to be feared. It can indicate danger, but it can also signal opportunity. What is crucial is that investors are able to determine which and have a plan ready so they can react appropriately.
How investors approach volatility depends critically on the immediacy of their targets. Short-term investors may find that volatility management techniques are useful. However, for those focused on the longer term, volatile markets can present significant opportunities to enhance results. In this article, we try to quantify the short and long term and look at ways investors can overcome their natural aversion to investing in volatile markets.
Defining our terms
Modern portfolio theory defines risk as volatility and tells us that there is a proportional relationship between volatility and expected returns – an investor must accept uncertainty if they are to generate returns in excess of the ‘risk-free rate’. Thus it is most efficient to minimise volatility for a given level of return, or maximise returns for a given level of volatility.
Under this definition, volatility is a measure of the variation in results, typically expressed as their standard deviation from an average level. This can, however, lead investors astray. Take the simple example of two assets, A and B, in Figure 1. The statistical volatility of A is far higher than that of B; indeed, technically, B has zero volatility. However, it is obvious that, over the three-month reference period, asset A was the better investment to own.
There are, of course, many other ways of defining investment risk. For many investors it is simply the possibility of permanent loss, but for some it is more specific. For example, a pension fund might consider its main risk to be having insufficient assets to meet the retirement needs of its pensioners. For a sovereign wealth fund, the most worrying issue might be owning a stake in a company involved in some illegal activity. Insurance companies, on the other hand, might consider the major risk to be illiquidity, i.e. not being able to sell assets when needed to pay claims. For most investors, an ever-present concern is whether the purchasing power of their money will be eroded by inflation.
It is clear that the terms ‘volatility’ and ‘risk’ are not synonymous. Yet, although they are used more or less interchangeably, very few people would be satisfied if the answer they received to the question ‘what’s the risk of this investment?’ was simply ‘five’.
Much analysis of risk assumes that an investment is affected in the same way whenever returns occur. In truth, of course, timing is vital. A 10% market fall when a saver is 25 and their accumulated savings are small should be much less traumatic than when they are 45 and their savings are likely to have grown to something more substantial. The order in which returns takes place can make a significant difference to the final outcome. This is sometimes termed ‘sequencing risk’ – the impact of the pattern of returns on money-weighted results.
Crucially, higher volatility increases the exposure to sequencing risk. Figure 2 shows the sensitivity of a pension saver to this risk. The blue line represents the hypothetical savings of someone who started a defined contribution (DC) pension in January 1974 and retired 40 years later. (We have assumed that they had average UK earnings, of which they saved 10% annually, and maintained a 60:40 allocation between equities and bonds.) By the time they retired they had savings of almost £500,000.
The orange line shows what might have happened had they instead experienced a bull market in equities and bonds in the last few years leading up to retirement. We created this alternative scenario simply by switching the relatively poor returns of the 2000s with the relatively strong returns of the 1980s. The switch has no impact on compound annual total returns over 40 years measured on a time-weighted basis. However, it does have a major impact on the final value, because the strong returns in the final decade acted on a much larger sum of money. In this scenario the final sum is over £1,000,000 – more than double that of the ‘actual’ DC saver. This exercise highlights the heavy toll on our saver’s pension pot caused by the flat-to-falling returns of the 1990s and the crash of 2007–2008, both of which happened late in their savings journey
In short, therefore, the final value of DC pension savings is very dependent on the path taken. An early setback will have limited impact on the end result, whereas a market crash close to retirement can mean serious impairment.
Since, intuitively, lower volatility leads to a tighter range of expected outcomes, managing portfolio volatility is one way to attempt to try and manage sequencing risk. However, there is a cost to this approach in terms of lower expected returns, and at times this ‘insurance premium’ is too expensive. Moreover, simple volatility management is a blunt instrument at best as it can only give some control over the magnitude of possible losses, and none over their incidence or timing.
An alternative way to control sequencing risk is through active management of the portfolio to try and avoid steep falls in value. This leads to outcome-oriented strategies, such as low-volatility hedge funds, flexible fixed income or multi-asset portfolios. In practice, a blend of these solutions is perhaps useful. Having available a range of outcome-oriented strategies with varying targets and volatility tolerances will help in striking the right balance between achieving real returns and avoiding major crashes.
Important information: For professional investors only. Not suitable for retail clients. The views and opinions contained herein are those of the authors, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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