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a chart with red and green data points showing market price volatility overlaying an image of a woman's hand at a keyboard ordering asset trades - exercising investment risk and volatility decisions

Investment Risk and Volatility

Investment Risk and Volatility influences Investor behaviour.

Investment Risk and Volatility are market bedfellows.

Investor behaviour can range from excited speculation to mindless crowd-following.  Speculators getting on to emerging ‘sure things’; mindless crowd-followers getting out of assets falling in value. These random swings between euphoria and fear create market fluctuations (measured and reported as market volatility).  Analysts, traders and economists track volatility over the history of individual market assets and components.

Extreme and/ or frequent volatility in markets gives rise to investor risk anxiety. Volatility may not be such a concern to investors if investors understood that the liquidity issue is their biggest threat.  Getting out of an asset that is falling crystalises losses that may be avoidable.  Applying a strategic approach to the decision may preserve the longer-term value of a portfolio.

Taking the share market as an example

Because shares can be bought and sold at any time during the trading day, changing prices are being negotiated.  These prices are influenced by the underlying forces of supply and demand for the asset. When buyers (demand) outnumber sellers (supply) the price will invariably be rising.  Unsurprisingly, the opposite occurs when sellers outnumber buyers. You may well be familiar with how this works in the home sales market.  There are times when it is better to be a buyer; and others, to be a seller.

Should market volatility of itself, lead an investor to make a transaction (buy, or sell) decision?

To answer this question we need to review some factors in the investment process.

Is there a relationship between investment risk and volatility – and economic value?

Volatility represents fluctuations in the market price of an asset (share/ property etc).  It is important to understand that it does not necessarily mean there has been a change in its economic value.  (The economic value of an asset is measured by its ability to provide a consistent revenue stream for instance).

A share that is traded on the share market represents a stake in the ownership of a listed company. The value of a company can be determined by summing its net assets (all tangible assets less liabilities).  This is then compared with the sum of its projected future cash-flows (dividends) and discounted back to present day dollars.

There is a clear difference between the net asset value of a company and its market capitalisation. (The market capitalisation is calculated by multiplying the number of shares on issue by the market price).

What to take from this…

If we assume that the share price of a company on a given day is a reasonably accurate reflection of the investment value of the company at that time, then –

  • fluctuations in that price will merely indicate that some investors are paying
    • a fair price,
    • others a cheap price,
    • and yet others, an expensive price –
  • despite the fact that the underlying assets and projected discounted cash-flow, is in fact unchanged by each trade.

Hence we see that the price of shares varies as a function of market liquidity.  As mentioned earlier, liquidity is created on market by the fact that shares can be traded almost instantly.  Buyers and sellers are constantly exchanging bids and settling trades to suit their individual goals.

Imagine if you will, a situation where both buyers and sellers were acutely aware of a company’s true present value at say $5.00 per share. In a static world you might expect that the share would be exchanged at this price.  In reality this may on occasions happen – but that will be pure coincidence.  More commonly, however, humans are invariably driven by individual, different motives at any given time. (We encourage applying a strategic plan to the decision to trade at all times).

Buyers will purchase at the lowest possible price; and sellers will trade at a ‘best’ price.  Each will set their trade price according to their prevailing circumstances.

Investment risk and volatility: asset/ market liquidity?

Understanding these market features helps explain that the price of shares (as an investment asset class) can be volatile because they are extremely liquid. Residential property, on the other hand is much less volatile simply because it is relatively illiquid. In terms of investor risk the concern is the risk of capital loss, impacted by timing decisions: capital risk abounds predominantly if you are forced to sell – “volatility is not the issue”. Both shares and property pose potential for both capital gains and capital losses depending on the price movement over the period for which the investor ‘chooses’ to hold them.

Most of us understand that you should be prepared to hold a property (any property: whether residential, industrial, commercial or other)  for a considerable period of time (even years) to be reasonably confident of a capital gain, barring improvements being made and other ‘external’ factors (such as zoning issues etc). We are conditioned to accepting that property is generally a long term undertaking: we are not in the habit of trying to establish the value of property every other day (such as we do with publicly-listed shares).

Major corporations listed on stock exchanges are long term enterprises looking to accrue value over time through ongoing positive cash-flows. Investors who understand this will realise that listed company shares are arguably the least risky in terms of capital protection – provided they remain in a position to choose the timing at which they will transact.

Sequencing risk is the loss of timing control

The effect of ‘sequencing risk’ is that intended timeframes need to be extended for investors to achieve their goals. Investing is a long term undertaking involving exposure to assets that produce returns in excess of the cost of capital (cash and borrowings) over a prolonged period. Property and SME business owners intuitively – and acutely – understand this, as do even the not-so-sophisticated investors. (Curiously when it comes to shares, we often see investors applying different standards which have no basis in logic.) What happens however, if at some point in time there is an inevitable ‘correction’ in market prices?

If you have invested in a residential property in then middle of a market cycle, intending to hold that property for say, seven years – and two years after you purchase there is a fall in the housing market prices: it is unlikely that you will take much interest in that price fall (because it is your intention to hold for a further five years yet!). What if that fall happened just when your investment term was closing out? If you have been counting on a particular sale price, your future plans may well be affected – and you may need to either bight the bullet and take the ‘loss’; or merely extend your holding period.

‘Time in the market’ -v- ‘timing the market’ is an important distinction: where the extent of volatility is extreme – and it coincides with a loss of timing control, the consequences can be catastrophic for the investor. This is understood by those who have retired and are relying on their existing, non-replenished capital when downward volatility hits the market. In relatively recent years we experienced a global financial crisis (the GFC) which seriously impacted a number of investors (including self-funded retirees) in this way.

Wealth management is financial risk management – may we be of service?

The Continuum Financial Planners Pty Ltd team of advisers are experienced in providing advice to clients that guides them to mitigate investment risk factors.  This enhances their wealth management process and outcomes.  We operate with empathy – ‘we listen, we understand; and we have solutions’ to your financial needs, goals and objectives.  We operate openly, documented in detail ‘personalised, professional wealth management advice’.

To discuss the possibility of engaging with us to experience the benefits of our existing clients, please –

(Originally posted in March 2011, this article has occasionally been revised/ updated, most recently in August 2024)