Volatility and the Cost of Market Returns
Volatility is often perceived as something to be minimised or engineered away by investors, which is understandable but misguided. Volatility is less of a flaw in the market, and more of the price of admission to the returns those markets produce.
Why The Premium Exists
The equity risk premium reflects the equilibrium price of equity market risk. It is the premium investors demand in order to hold aggregate equity risk, and it is determined by investors' collective risk aversion together with the volatility of the equity market itself. (Norges Bank Investment Management, 2016).
Consequently, an investor who requires the returns equities have historically delivered must accept the variability that accompanies them. The two cannot be decoupled, and any product that claims to have separated them deserves scrutiny rather than enthusiasm.
An investor who requires the returns equities have historically delivered must accept the variability that accompanies them. The two cannot be engineered apart, and any product that claims to have separated them deserves scrutiny rather than enthusiasm.
Volatility can be reduced, but reduction has a price. Holding more cash, short-dated bonds or defensive assets lowers a portfolio's variability. It also lowers its expected return. Depending on the investor's circumstances, that may be entirely the right decision. What matters is recognising it as a trade-off rather than an improvement.
The real risk for most investors is not volatility itself but their reaction to it. A portfolio that falls 25 percent and recovers has cost its owner nothing but discomfort. A portfolio that falls 25 percent and is sold at the bottom has turned a temporary decline into a permanent loss. The market did not destroy that capital. The decision did.
This is why time horizon does more work than almost any other input in portfolio construction. Volatility that would be unacceptable over eighteen months becomes tolerable over fifteen years. The asset hasn't changed; the investor has gained the ability to wait.
The Useful Reframing
There is a difference between volatility and risk that is worth holding onto. Volatility measures how much a price moves. Risk, properly understood, means the permanent impairment of capital. An asset that swings considerably and recovers was volatile. An asset that quietly declines and never returns was risky. The two are frequently confused, and the confusion leads investors to fear the wrong thing.
A portfolio designed to feel comfortable in every month of every year will almost certainly underperform one designed to be held through difficult periods. Comfort is a legitimate objective, but it is a purchased one, and the currency is return.
Understanding volatility as the cost of market returns rather than as an unwelcome accident changes the question an investor asks. It is no longer 'how do I avoid this,’ but rather ‘how much of this can I genuinely tolerate, over what horizon, and is the compensation adequate.’
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This article is general information and does not constitute investment advice, an offer, or a recommendation to invest. Marigold Capital Advisors Limited is regulated by the Dubai Financial Services Authority, and its services are available to Professional Clients only. Past performance is not a reliable indicator of future results, and different types of investment carry varying degrees of risk.