Challenge of volatility in world markets
Investment markets have been no place for the faint-hearted over the last twenty years. In the latest issue of Asset Marcus Brooks, Director at Cornelian Asset Managers explores the challenge of volatility in world markets and explains why by combining various investments overall volatility can be
Investment markets have been no place for the faint hearted over the last twenty years - The Asian Financial Crisis 1998, the “Dotcom Boom” 1999, the “Dotcom Bust” 2000-2003, The Global Financial Crisis 2007-2009, wars, recessions, high profile corporate collapse/fraud have all played a part. The recent performance of the Chinese equity market where retail speculation was rife and where the Shenzhen A Share Index rose over 190% in the eighteen months to June 2015 before collapsing by close to 50% by the middle of September and dragging other equity markets down with it is just a further illustration of what can happen. Markets have always been subject to the bubbles and busts that result from the manias, irrationality, over-exuberance, undue pessimism and greed that are a few of the many parts of the human condition. Living through such periods can be an exhilarating or depressing experience depending upon one’s positioning but the same feelings will have been experienced by those participating in the Dutch Tulip mania of the 1630’s or the South Sea Bubble of 1720. For more prudent investors, sticking to a few rules can help to alleviate the worst of these fluctuations.
Logically, the more risk you are prepared to take, the larger the reward should be (both potential and actual). Risk, in investment terms, tends to be measured by volatility. By that we mean the amount by which the return on an asset varies over a short period, typically a year, compared to its long term average annual return. There is some sense in this – long term returns on many assets, including equities, have been very acceptable but over shorter time periods the potential for capital loss, sometimes significant, is substantial because annual equity returns are volatile. Therefore, the first rule when investing is to be clear on your timescale. If you are unable to tie up your money for a long time (or be prepared to take a capital loss) you should not be considering investing in risky assets – Warren Buffett professes no interest in the short term fluctuations in the share prices of his investments and has been vindicated in his faith that the value he sees in his holdings will be realised over the long term.
The volatility or riskiness of asset classes or indeed individual holdings within asset classes vary – annual returns on cash or gilts have fluctuated much less wildly than equities but the long term average return on cash and gilts is much less - if you are concerned at the possibility of capital loss over short time periods then these are the types of assets you should consider. However, it is worth bearing in mind that less risky in this case does not mean without risk, especially when inflation is factored in. In real terms, there have been years over the last century when cash returns have been minus 16% and gilts minus 50%!
The fact that the volatility or riskiness of investments vary means that by combining various investments, overall volatility can be adjusted to suit individual circumstances. In addition, not only do returns and volatility vary between investments and asset classes, but it is also true that not all investments move in the same direction or to the same degree over the same time period – their returns are not all perfectly positively correlated. For example in 2008, as equity prices fell sharply, gilts offered positive returns, while in the period post 1999 when investors in many dotcom companies that had risen so sharply saw their investments crash back, investors in tobacco companies and utilities made attractive gains.
It follows that holding a portfolio that is reasonably diversified between asset classes and individual holdings should offer a less volatile annual return because movements in value of one holding will be cancelled out or tempered by movements in another. It is for this reason that Cornelian portfolios contain not only equities, bonds and cash but also commercial property, a variety of absolute return funds, infrastructure and index linked securities all of which offer different risk and return profiles.
Building a portfolio that combines a variety of asset classes and holdings is the key to sensible investing and portfolios can be structured to suit individual risk tolerances. Alternatively buy and be prepared to hold the riskier asset classes over a long period of time.