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Global capital markets have been extremely volatile during 2022. Stock markets are experiencing large daily movements that are high relative to history. In addition, most bond markets around the world are experiencing their worst performance in decades.
Over the past several decades, investors came to expect that stocks and bonds would move in different directions. When the stock market experienced large declines in value, it was typical to see bond yields move down; this resulted in bond values moving up and offsetting some of the negative stock performance.
In investing jargon, that relationship is referred to as negative correlation. This means that when the value of one asset moves in a certain direction, a negatively correlated asset would move in an opposite direction. This is a beneficial outcome, as your investing experience is smoothened out and you do not experience extreme highs or lows. Of course, we would all like to have extreme highs, but it is not reasonable to expect that the highs can occur without assuming the risk of the lows. When we are able to own assets that have negative or less than perfect correlation, we expect that the volatility of our overall returns will be lower.
Volatility is the magnitude of movements in value.
In the chart below, the pink line represents a higher volatility experience, the green line a lower volatility experience and the blue line has no volatility. Higher volatility means greater movements and deviations in value. The actual returns of an asset are not determined by its volatility, but in the long term major return benefits can be realized by reducing volatility.
The mathematics of volatility are interesting and may not be intuitive. For instance, if an investment portfolio loses 20% in one period and gains 20% in the next period, the average return of that portfolio is 0%. But unfortunately, the ending value of the portfolio is 4% lower than the starting value (as the worked example below explains).
You would have to earn 25% in the next period to get back to where you started. And as the percentage decline worsens, the return required to get even increases: if you lose 50%, you need to earn 100% to get back to even. This is the hidden impact of volatility. The decline of 50% represents a higher volatility outcome than a decline of 20%, so there is definitely a benefit obtained from reducing volatility.
A lower volatility portfolio will generate more ending value than a higher volatility portfolio that earns the same average return. In the volatility chart above, each line has an average return of 7.3% but the higher (pink) and lower (green) volatility lines both fall short of the no (blue) volatility line with the high volatility line falling extremely short.
Well, have you ever noticed that it is more common to see stores that service both bicycles and snow skis than bikes alone or skis alone? That is because a store that services only one or the other will have highs “in season” and lows “out of season.” However, a store with both lines of business will have a more consistent experience across all seasons. This is a real-world illustration of the concept of diversifying by combining non-correlated items, with the ultimate goal being to reduce the volatility of a business’s profits and activities.
Takeaways
The key takeaway from this article should be that reducing volatility is a key component in constructing optimal investment portfolios. The most effective method for reducing volatility is to ensure that your portfolio is diversified by combining as many different and non-correlated assets as is feasible. By doing so, you increase your chances of avoiding extreme lows and ideally generating a greater amount of wealth in the long run.
* Concept borrowed with permission from Resolve Asset Management
The Winnipeg Team
Africa