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Investment Risk and Volatility

Investment Risk and Volatility influences Investor behaviour.

Investment Risk and Volatility are market bedfellows.

Investor behaviour can range from the fervour of excited speculators anxious to get on to ‘a sure thing’, to that of  lemmings leaping off a cliff – getting out of the assets they see falling in value, as quickly as they possibly can. These random swings between euphoria and fear, when enacted as trades in the assets they hold, create what is referred to as volatility (a measure of the upward and downward movements of the markets) which analysts and economists track over the history of the market for particular assets.

Extreme and/ or frequent volatility in markets gives rise to investor risk anxiety. Volatility may not be such a concern if investors understood that it is a by-product of liquidity rather than a threat to the medium- to long-term value of a portfolio. Taking the share market as an example: because shares can be bought and sold on the market at any time during the trading day there are constantly new prices being negotiated for each trade – and these prices are influenced by the underlying forces of supply and demand. When buyers (demand) outnumber sellers (supply) the price will invariably be rising; and the opposite occurs when sellers outnumber buyers. You may well be familiar with how this works in the home sales market as well: 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) but it is important to understand that it does not necessarily mean there has been a change in its economic value (its ability to continue 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), with the sum of its projected future cash-flows (to an investor, dividends) discounted back to present day dollars. Whilst this may appear as economic jargon, there is a difference between the value of a company (refer the previous sentence); and its market capitalisation (the product of multiplying the number of shares on issue by the market price).

If we assume that the share price of a company on a given day is a reasonably accurate reflection of the true 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, i.e. the measure of value, is in fact, unchanged by each trade.

Hence we see that the price of shares varies as a function of the fact that they can be traded almost instantly in a market situation, where buyers and sellers are constantly exchanging bids. 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, and in reality this may on occasions happen. More commonly, however, humans are invariably driven by individual, different motives at any given time (hopefully applying a strategic plan to the decision to trade at that time). Invariably buyers will be looking to acquire at the lowest possible price within their permissible timeframe; sellers will decide the acceptable sale price for 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 in the mitigation of the risk factors in their wealth management process. We operate with empathy – ‘we listen, we understand; and we have solutions’ to your financial needs, goals and objectives that we present in documented ‘personalised, professional wealth management advice’. If you would like to discuss the possibility of engaging with us to experience the benefits of our existing clients, please phone our office (on 07-34213456); or use our website Contact Us facility, to arrange a meeting.

(Originally posted in March 2011, this article has occasionally been revised/ updated, most recently in October 2018)

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