Volatility (the propensity of an investment to gain or lose value over time) is not a good measure of investment risk, but volatility poses a large and not well understood risk to you as an investor. This statement, which seems to be contradictory but is not, is the view of Matthew de Wet, the head of investments at Nedgroup Investments.
And he says volatility poses a particularly real risk for people, such as pensioners, who are living off their savings.
De Wet says using volatility to measure risk (as advocated by modern portfolio theory) has become antiquated in practical investment management circles. The reason is that volatility, or the historical degree of (non-permanent) price variation of a particular security, is not an adequate measure of the future and actual risks that investors face. These risks include the risk of a permanent (realised) capital loss, the risk of inflation eating away your returns over time, and shortfall risk (the risk of not having sufficient savings to last through retirement).
He says that instead of seeing volatility as a risk, “it is currently quite fashionable to embrace volatility as the source of investment opportunities – volatility is used to buy low and sell high”.
However, he warns that “the humble law of averages unfortunately ensures that there will be as many losers as there are winners who attempt this”.
Graph one highlights the degree to which volatility can erode returns. Two funds (Fund A, which has low volatility, and fund B, which has high volatility) are compared over a 20-year period. Both funds, which start with an investment of R1 000, provide an average return of 12 percent a year, but fund A has half the volatility (10 percent a year) of fund B (20 percent a year). Over the 20 years, the high-volatility fund B under-performs the low-volatility fund A by 25 percent on a compound basis, even though both funds have the same average annual return. The lower cumulative return of the high-volatility fund B is simply due to the fact that compound returns are rendered less effective by volatility. (Put another way, the higher the volatility, the larger the gap between average and compound returns.)
De Wet says this “volatility attrition” is exacerbated when investors are withdrawing from their post-retirement savings but it has a more muted impact when investors are adding to their pre-retirement savings.
He says there are many ways to reduce the volatility that can be expected to undermine your savings and your income in retirement.
The most common way is to reduce the allocation to volatile asset classes, such as equities, or to hedge out or “insure” some of the equity exposure by using derivatives. But for these approaches to be effective, you need to get the investment “call” right. Furthermore, they tend to have a cost (either explicit costs or the opportunity cost of not gaining the full advantage of the growth in investment markets), which can result in a reduction in your returns.
In other words, by avoiding volatility you may receive lower investment returns.
De Wet says that, fortunately, there is one easily implementable and powerful free lunch in investing: diversification.
“By simply investing in a mix of different asset classes that react differently to market conditions, investors can materially reduce the volatility of their portfolios without necessarily impacting returns.”
Table one quantifies the benefit of diversification of a simple portfolio that consists of local equities and local bonds, based on historical return and volatility data from 1960 to 2009.
The table shows that for a portfolio of 60 percent equities and 40 percent bonds, the expected volatility was 16.1 percent, while in reality it was 14 percent, just over two percentage points lower than the weighted average volatility of the components.
This 2.1-percentage-point reduction in volatility is the free lunch – the benefit of combining assets that are not perfectly correlated, which means the returns of the two asset classes do not move in tandem. One asset class could be losing value while the other asset class is increasing in value.
De Wet says diversification is even more effective when additional asset classes are added to the mix.
In table two, a quarter of the equity and bond portfolio is allocated to offshore equities and bonds to spread the volatility risk further. De Wet says this is not to try to create the most efficient portfolio with the benefit of hindsight, but rather as an example to show the benefit of spreading risk further.
The table shows that for a portfolio invested 60 percent in equities (45 percent local and 15 percent offshore) and 40 percent in bonds (30 percent local and 10 percent offshore), one can expect a portfolio volatility of 16.6 percent, but in practice the realised volatility is a full five percentage points lower at 11.6 percent – an even bigger free lunch than that offered by the local-only portfolio.
De Wet says the reduction in volatility, relative to the local-only portfolio, was not at the expense of returns. These were, in fact, nearly one percentage point a year higher over the period in question.
The tables show that for a pensioner who withdraws an income of six percent a year, diversification may reduce the expected volatility by five percentage points. Over 20 years, this equates to investors having nearly 50 percent more money than if they had not harnessed the benefits of diversification.
De Wet says the lesson is not to discount the impact of volatility too soon. Although it is a poor measure of risk, it poses a very real threat to investors, especially those who are living off their savings. “The simplest and most cost-effective way to reduce volatility without necessarily sacrificing returns is through sensible diversification,” he says.
HOW SAVINGS ARE AFFECTED
Graph two tells two stories, namely how high levels of volatility erode the incomes of pensioners and that pensioners are the biggest victims of investment volatility.
The chart shows how an increase in the level of volatility reduces the level of potential savings and returns. The green line is a base line that represents returns that would have been received had there been no volatility.
The yellow line illustrates the impact of volatility on someone who is drawing an income from his or her savings.
Assume a pensioner is withdrawing as a pension six percent of his initial savings a year. The pension increases annually with inflation to ensure a comfortable standard of living. The investment is producing average returns of 12 percent a year.
The yellow line illustrates how much lower the investor’s potential returns will be after 20 years, purely due to volatility. The higher the volatility (horizontal axis), the greater the “volatility attrition” or proportion of returns eroded (as measured on the vertical axis).
The three markers on the yellow line correspond to the following situations:
* Zero volatility. In this case there would be no reduction in returns over 20 years.
* 10 percent volatility. In this case there would be a 25-percent reduction in returns when compared with a zero-volatility fund.
* 20 percent volatility. In this case there is a 70-percent reduction in the potential value of returns over 20 years when compared with a zero-volatility fund and a 60-percent reduction when compared with a fund with a volatility of 10 percent.
The red and blue lines on the graph illustrate the impact of volatility on an investor who is saving for retirement (red line) by contributing an additional six percent a year and an investor who is not making contributions or withdrawals (blue line). The volatility attrition is much lower compared with when investors are withdrawing from their savings (yellow line), because they are not locking in losses during times of market weakness and reducing the base from which to compound when markets recover.
* This article was first published in the 4th quarter 2010 edition of Personal Finance magazine.