“Not seeing a tsunami or an economic event coming is excusable; building something fragile to them is not.”
[Nassim Nicholas Taleb]
After an extended period of benign equity market conditions, February 2018 saw the return of volatility. Rather like seismologists, portfolio managers are continually monitoring for signals of a ‘financial earthquake’, but predicting the exact occurrence of an event remains to a large extent a futile obsession.
However, we can learn from experience and existing knowledge that there are fault-lines in markets and areas of seismic activity around which one might expect events to occur. On that basis, active managers endeavour to position client portfolios in safer-zones.
In this article we are not going to speculate on what caused the most recent spikes in volatility; instead, we are going to assess the impact of volatility on private client portfolios with the aim of equipping trustees and advisors with a simple set of conceptual tools to prepare for and protect against seismic activity, whether that’s a minor tremor or major quake.
Understanding the difference between Volatility and Risk
“Volatility is not the same thing as risk, and investors who think it is will cost themselves money.”
The first task is to have a clear understanding of what volatility is. Often it is conflated with risk; it is fundamentally different.
Volatility, in financial terms, is best defined as a statistical measure of the dispersion of returns for a given security or market index. Volatility can be measured by using the standard deviation or variance between returns from that same security or market index.
Risk, at its most basic level in financial terms, is defined as the uncertainty associated with any investment and that the actual return will differ from an expected return.
The key fundamental differences are as follows:
- Volatility is objective and quantifiable; risk is subjective and requires qualitative analysis.
- Volatility is backward looking and moves quickly; risk is forward-looking and tends to move slowly.
- Volatility is the same for all participants in a given market; risk depends on a client’s circumstances and financial landscape.
One of the most commonly held false assumptions in portfolio management is that one must take higher risks to generate higher returns. More accurately, if you want high returns, high volatility is mandatory, high risk is not.
The absence of volatility is not normal and is, in fact, counter-productive for market participants in the long-term as it masks hidden dangers and creates a false sense of security, fostering expectations that high returns can be generated in low volatility environments.
Our industry has a tendency to use terms that many clients and their advisors may recognise but not fully understand. Two useful tools that we refer to frequently are Beta and Fat-tails, that can be defined as follows:
The Beta of a security is the measure of the volatility of the security in relation to a market. A security with a Beta of 1.0 will move in unison with the market, securities with a Beta greater than 1.0 tending to be more volatile than the market, and those with Betas below 1.0 tending to be less volatile than the market.
Fat-tails refer to the statistical probability distribution of an event being skewed rather than having a bell-shaped (normal) profile. In simple terms, it means that there is a relatively high probability of a relatively extreme event occurring.
Having the ability to assess the Beta of a financial asset, whether that is a single stock or fund enables a manager to position portfolios to seek or shelter from volatility. Understanding that some markets and asset classes have fat-tail profiles helps us to optimise the overall asset allocation strategy and to tailor these to suit a client’s personal and subjective risk profile.
Having started with a quote from Nassim Taleb (author of The Black Swan, Antifragile and most recently Skin in the Game), I’ll close with the following from the same author:
“It is far easier to figure out if something is fragile than to predict the occurrence of an event that may harm it.”
If you are unsure of the current positioning of any of your client portfolios, MitonOptimal would be pleased to provide you with quantitative and qualitative analysis of your asset allocations to identify any potentially ‘fragile’ assets and to assist in positioning portfolios appropriately now that volatility has returned to markets.
Footnote: Greg will be speaking on the subject of understanding the difference between volatility and risk in client portfolios at the STEP Barbados conference in May 2018.