Volatility is a crucial aspect of risk management, but needs a higher level of understanding, writes Allianz Global Investors' Nick Smith...
Since the beginning of the current debt crisis, the word ‘volatility’ has become even more prevalent in the lexicon of financial services professionals, the media and, increasingly, the public at large.
But the wider proliferation of the concept of volatility hasn’t led to a better understanding of what it really means, and the effect it can have on your clients. We believe that, in order for advisers to deliver the best service to their clients, they should fully understand what is meant by volatility, and how it applies to them.
So, what is it? Volatility is a way of measuring the dispersion of returns of a certain security, asset class or index.
Why volatilty is still an important tool in understanding risk
When looking at volatility in its most basic form, most of the returns are bunched around the centre of the distribution, creating the familiar bell curve shape as shown in figure 1 below. This is a normal distribution.
Once we have a distribution of returns, we need to understand their spread. This is where we apply a standard deviation, which is a statistical measure that defines how much returns are spread.
We also know that the concept of a normal distribution does not always exist in financial markets. This is where the idea of a ‘fat tail’ comes from. When a portfolio of investments is put together, it is often assumed the distribution of returns will follow a normal historical pattern.
As you can see in figure 2 below, if we include the dark blue, light blue and red areas of the distribution this accounts for 99.97% of the possible returns. This means that the possibility the returns will move outside this area into extremely negative or positive territory is 0.03% – or virtually nil.
However, as markets have taught us, distributions are rarely normal, and are in fact skewed. The distribution therefore has fat tails as shown in figure 3 below. This shows a more realistic distribution where, as we know, the return will move beyond three standard deviations more regularly than a normal distribution would suggest.
Along with this is the problem of the historical bias of asset managers. Funds that look exclusively at long-term volatility and apply no forward-looking judgement may not understand the potential problems that lie ahead.
For example, in the run-up to 2007/2008, mortgage-backed securities did not display the type of significant volatility that was to come in the months that followed. It seems clear that volatility as measured by standard deviation is not a simple and readily understandable concept. Not only is its calculation tricky, but is has several clear shortcomings as a pure measure of risk.
We know that since 2008 markets have exhibited increased levels of volatility. This is illustrated by figure 4 below, which shows volatility prior to the financial crisis and in the years afterwards. We believe this volatility is unlikely to decline quickly as the global economy goes through a significant period of deleveraging, and governments enact policies designed to apply financial repression.
In this kind of low-yielding environment with excess liquidity generated by central banks, investors all surge towards the asset classes offering the highest expected total return.
At some point, however, valuations will become excessive, and the upward momentum that has been driven largely by inflows into these often less liquid assets can reverse dramatically. These rises and falls increase volatility and make generating positive returns harder.
What does this mean for advisers?
From an investment perspective, despite its shortcomings volatility is still an important tool in understanding risk. It should be used along with other risk measures in order to fully account for the potential risk in a portfolio.
For many advisers, due to the challenges of RDR and the complexity of the investment and risk management process, it is becoming increasingly prevalent to outsource the investment process to a third party.
In this instance, it is vital to ensure that risk is being monitored in the best possible way through due diligence. In the current market environment of heightened volatility, strong risk management is even more necessary to limit losses and maintain gains.
From the perspective of your clients, any conversation about volatility and standard deviation is likely to be complex. Advisers should endeavour to use more simplistic language to describe what this means, and frame the conversation in terms of the likely losses and gains that can be expected.
They should also explain that volatility works in both a positive and negative way, and that for many clients to reach their long-term savings goals they may well need to add more risk to their portfolios, potentially increasing their volatility.
Figure 1: A normal distribution:
Figure 2: Standard deviation
Figure 3: Fat tails in a skewed distribution
Figure 4: Volatility has increased
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