Understanding Volatility

by | Jul 21, 2014

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Volatility is a crucial consideration when picking suitable funds for clients, says Gavin Counsell, multi-asset manager at Aviva Investors. 

There are many measures of investment risk, but the most commonly used measure is volatility.  Unfortunately, though, while common, it can also be open to different interpretations. As fund providers generally measure fund risk by reference to volatility, understanding volatility can be vital to creating suitable client portfolios.

What is Volatility?

Volatility illustrates how much an investment’s price fluctuates, and it can also measure the extent to which actual investment returns differ from expected returns. Typically, volatility is measured in percentage terms – the higher the figure, the higher the investment risk. For example, long-term volatility levels for equities are typically 15-20 per cent a year, while levels for bonds tend to be 5-7 per cent a year. In other words, equities are around three-times more volatile than bonds.

In general, the higher the volatility, the higher the expected returns over the long term. So, while equities are generally more volatile than bonds, they should also outperform bonds over the long term. The question is whether a client can cope with roller-coaster returns or prefers smooth returns on the way to their ultimate goal.

One point to note is that volatility captures both potential gains and losses over a period. All too often, when discussing volatility with clients, they focus far more on possible losses than gains.

Why Volatility is Important

It is crucial that clients are aware of potential risk exposures before investing. Different clients’ attitude to how much risk they will accept varies. So, some clients may tolerate annual investment losses of up to 2 per cent of fund value, while others will stomach annual losses of 10 per cent or more. Similarly, some clients may want annual returns within a narrow range of say 5-9 per cent over a given period while others may accept a far wider range.

Understanding the drivers of volatility for asset classes, and funds, and the potential impact volatility that has on returns can allow you to think about a portfolio’s overall risk more holistically.  In turn, this can help you construct portfolios for clients targeting returns that are as smooth or volatile as they want.

Fund Suitability

It is imperative that you choose funds that are suitable for clients’ risk and return investment goals, or you risk falling foul of regulatory requirements under the Retail Distribution Review. Comparing different funds’ volatilities, and understanding what this means to the risk exposure, is an important step in investing in the appropriate fund.

Any fund chosen for a client must meet their risk tolerance at the point of investment and must remain so while they hold the fund. This can be done by monitoring the levels of risk within the fund or alternatively choosing a fund that is expected to maintain a managed level of risk.

Conclusion

It is crucial that clients choose funds that are expected to produce risk levels matching their attitude to risk. Understanding volatility and how this could affect a fund’s performance can be very useful in doing so, helping ensure the most appropriate funds are picked for clients.

 

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