23 Apr Portfolio Analysis Basics #3 – Focus on “Volatility”
The word “volatility” has inherently negative connotations for most people, maybe with the exception of the adrenaline-seeking few who enjoy the thrill of the rollercoaster ride. However, there is absolutely an upside to be considered with volatility; the emotional “high” achieved via the rollercoaster ride as compared with the relative boredom of opting out.
In this week’s article I’m going to focus on what “Volatility” means in a portfolio construction context, and why it is important to understand how much you are comfortable with.
Volatility – what is it?
Volatility is the degree to which the value of a fund (and therefore the value of a portfolio which contains multiple funds) fluctuates up and down over a time period.
When one looks at historic levels of return over long periods of time, it is equities which have the advantage over bonds, however with that superior level of return comes an increased level of volatility.
Simply put, the greater the proportion of equities in your portfolio, the greater the level of volatility you will experience but also the greater the level of returns if you hold the portfolio for a suitably long period of time to “ride out” the volatility.
Okay. So, how do I work out how much volatility I can take?
Determining a client’s true appetite for risk (and, hence, volatility) is one of the key steps in the financial planning process. It is achieved via a series of questions to determine the client’s response to various investment scenarios, whilst also considering what proportion of the client’s net worth is being invested, for what time horizon and, critically, what their emotional response to loss actually is.
It is a well known tenet of behavioural finance that human beings react much more negatively to a loss than positively to a gain. Researchers have termed the resulting bias “loss aversion” and demonstrated that people prefer to avoid losses around twice as much as they enjoy making gains. Given that behaviour as a baseline for the general population, it would seem reasonable to conclude that every client will be somewhere on a scale of wanting to avoid some proportion of the full volatility of a 100% equity allocation in their portfolio.
The end result of this key financial planning process is the categorisation of the client into a “risk profile”; broadly “Cautious” or “Balanced” or “Adventurous”.
From this risk profile, a suitable mixture of asset types (alongside equities) can then be proposed by the financial adviser so as to deliver the level of volatility that the client can comfortably live with, alongside a respectable return for that level of risk.
Visualising Risk vs. Volatility
Proposing a portfolio based on risk profile alone should only be a starting point. Following on from this, a discussion should ideally take place between client and adviser so as to fine-tune the allocations, based on detailed client preferences. This is the equivalent of getting a suit tailored rather than simply being allocated a “Small”, “Medium” or “Large” off-the-peg!
As input into that detailed discussion, I find the following visualisation of 3-year Return vs. Volatility of the various funds within a portfolio to be probably the most useful talking point to assist in finalising a portfolio for a client:
With Volatility on the x-axis and Performance on the y-axis, clearly the ideal would be to have 0 volatility and the highest possible return (i.e. a dot somewhere towards the top of the y-axis)! What we have, in reality, is equity funds providing the most return along with the most volatility (e.g. funds F1 and F2) and bond funds (e.g. funds F7 and F9) providing lower returns along with lower volatility. Cash is represented by F8, and unsurprisingly shows zero return (not factoring in inflation/deflation) and zero volatility.
The overall portfolio “Performance vs. Volatility” score is indicated by the blue square and, for reference, that of a “Balanced” benchmark portfolio is indicated by the brown triangle. The value added by this example portfolio (vs. simply following the “Balanced” benchmark) can be seen in the superior performance yet (marginally) reduced level of volatility.
Are you aware of the Volatility of your portfolio? Do you remember this being a talking point at the time your portfolio was put together? I often come across portfolios which have volatility levels which are not at all aligned with the risk appetite or capacity for loss of the client, and this can only be as a result of an incomplete risk profile assessment by the financial adviser involved and/or an “off-the-peg” portfolio allocation.
My own objective for this critical portfolio attribute is to come to a conclusion which has involved a discussion with the client; using an appropriate risk-profile-based benchmark as a reference point, and agreeing how much above or below its level of volatility the client is comfortable being.
Written by Michael Davidson
This article aims to provide information, it does not constitute financial advice, nor should it be relied upon as such. You should speak to a financial advisor regarding your circumstances before making a financial commitment. Global Financial Consultants Pte Ltd is a Licensed Financial Advisor and is regulated by the Monetary Authority of Singapore. MAS License number FA100035-3