Risk is not volatility
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Risk is not volatility

Updated
9
Jul 2024
published
4
Jun 2024
SOW: Risk is not volatility
  • Reflecting on what the historical data teaches us is what we refer to as the “science of wealth” because knowledge is king, not cash. Read the past The Science of Wealth columns. 
  • Many people use volatility and risk interchangeably. The two concepts are closely related, but are by no means the same.
  • People wrongly assume that the risk of an asset class remains the same in the short and long term. History shows this is not the case.
  • Market volatility is a given. Focus on the factors that remain in our control: knowing our own risk tolerance and capacity, understanding the right risks to expose ourselves to, choosing the right investment products that align with this, and minimising fees to improve outcomes.

The original version of this article first appeared in The Business Times

“Cash is king” has been the mantra ever since interest rates moved past 3 to 4%. That sentiment has persisted in an environment of sustained, higher-for-longer interest rates.

However, if we examine more closely the historical track record, we will see that this is just a normal interest rate cycle. When inflation falls, growth falters, and rates will fall with it. We should be prepared for possible future scenarios.

Reflecting on what the historical data teaches us is what we refer to as the “science of wealth”, because knowledge is king, not cash. Knowledge about financial market history or behavioural finance, enables us to make better decisions that will result in better outcomes.

This is why it is also helpful to take note of the data, not only from the market, but also from studies and research on investor behaviour and sentiment. These can act as important guideposts on where we are amid short and long-term trends.

Based on the Endowus Private Wealth Insights: HNW Investor Sentiment 2024 report, investors seem to be tired of getting just 3% from fixed deposits. They are starting to realise that this is barely above inflation, and will not help them grow wealth in the right way.

Notably, two in five (42%) of high-net-worth individuals (HNWIs) surveyed in Singapore plan to raise their allocations to hedge funds and private-market strategies as an important source of diversification. Such asset classes are less correlated to public markets, and could provide better risk-adjusted returns over the long term.

More importantly, the growing demand for alternative asset classes and private markets brings to mind a core investing principle related to risk and return, which are directly correlated.

Risk vs volatility

Among individual investors, risk brings to mind maximum drawdown, which is unidirectional – focusing on downside risk in absolute terms.

Therefore, we focus on knowing our limit for personal loss, both psychologically in terms of risk tolerance, and financially, in terms of risk capacity or the actual maximum loss amount we can withstand.

In contrast, volatility is an observable market phenomenon that can be measured independent of individual preferences. A swinging pendulum is volatility in action. It is about the intensity of price movements, regardless of direction.

High volatility means the price of a security can change dramatically over a short time, as reflected in statistical measures like the standard deviation of returns.

Many people use volatility and risk interchangeably. The two concepts are closely related, but are by no means the same. People also wrongly assume that the risk of an asset class remains the same in the short and long term. History shows this is not the case.

Warren Buffett made the distinction between the two concepts very clear, and explained why remaining in cash-like fixed deposits is actually a riskier investment.

He said: “Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions… Volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.”

His perspective is grounded in the belief that while the stock market can be unpredictable in the short term, it has consistently grown over the long term, reflecting the overall growth and expansion of the economy.

Therefore, for investors who are willing to hold onto their investments through the market’s ups and downs, stocks offer a valuable opportunity to build wealth with the compounding effect of returns over the long term, which is not provided by savings and deposits. In fact, the fixation with bonds and yields has led to a lot of leveraged losses in 2020, 2022, and again in recent fixed income volatility for many.

Appropriate vs inappropriate risk

Investors who equate price volatility with risk and fear its fluctuations may ironically find themselves engaging in detrimental behaviour and actions that are essentially high-risk. Undue fear of volatility, mistaken for risk, can drive decisions that are counterproductive, impulsive – and genuinely risky.

The behaviours include panicking at the first sign of trouble, and feeling compelled to switch to “safer” assets, even when the investment goals and appetite for risk have not changed from the time they were first set.

Or, in an attempt to shield their portfolio from price swings, investors may over-diversify too thinly across too many assets or sectors, diluting the potential returns from high-performing investments and exposing the portfolio to mediocre assets.

Some may also choose to shift into low-volatility – albeit lower-return – investments. While this might reduce volatility in the short term, it raises the risk that over the long-term risk, inflation could outpace returns and erode the purchasing power of the savings.

Such assets could dampen the volatility swings in a portfolio, but ironically they also raise the risk that long-term financial goals are not met.

Volatility may still be relevant when money is needed in the immediate future, for example, to purchase a home. But as your investment time horizon gets longer, the effect of volatility is reduced greatly, and you should really just be worried about risk.

Understand your own tolerance

Understanding our personal comfort levels with risk is crucial. Maximum drawdowns offer insights into potential losses in market downturns.

A particularly relevant and timely example is riding the Chinese equity rally. The market has seen its share of volatility; it weathered a significant 40% drawdown three times within the last 23 years.

The depth of the past slumps is very telling, but so is the duration for which the market or assets linger at their historical low points, essentially pointing to how long one may have to endure being in the red.

Ultimately, there is a trade-off between the allure of returns and the possibility of drawdowns. Investors need to find a balance that suits their risk tolerance, investment horizon and financial goals. This applies not only to single-country equities but also to traditional and alternative asset classes.

No risk, no return

Returning to the findings of the Endowus Private Wealth Insights report, it is clear that HNWIs in Singapore are willing to take on greater risks to achieve capital gains and maximise returns. Hedge funds and private market strategies are increasingly seen as vehicles to satisfy this appetite for risk.

In fact, private market investments have other risks such as the illiquidity risk that enables one to earn a higher risk premium or return over time. So by taking on the risk of not having access to your money, you are able to generate higher returns. Hedge funds often take on more risk by using leverage or derivatives, even as they target a lower volatility of returns.

Thus there is a broader discussion to be had about one’s willingness or capacity to take on risk. It is about understanding how much risk is acceptable, and what kind of risk one should be exposed to based on one’s investment goals.

The acceptable level of risk to build up savings for a child’s education can significantly differ from that taken for a retirement nest egg over decades.

This strategic approach ensures that one’s asset allocation is not only tailored, but is also reflective of one’s broader financial aspirations.

The bottom line is that market volatility is a given. What we should focus on are the factors that remain in our control: knowing our own risk tolerance and capacity, understanding the right risks to expose ourselves to, choosing the right investment products that align with this, and minimising fees to improve outcomes.

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