Dave Fishwick posted earlier this year on the extent of volatility aversion in the industry these days and the pivotal moment that we find ourselves in when it comes to asset pricing.
I want to avoid repeating Dave’s blog on why the emphasis on reducing short term volatility, which has been a successful strategy in the post-2008 environment, may be challenged going forward.
Instead I’d like to focus on another aspect of his piece; one that is often repeated but frequently ignored:
“In our view, true risk is more a function of the possibility of more protracted or permanent loss of capital. In our view, an obsession with volatility is counter-productive and misses the point about what actually matters on a multi-year view.”
Dave Fishwick, Time to stop hiding from volatility?, May 2016
Equities are traditionally regarded as more risky than bonds. From a ‘true risk’ perspective you can see why this might be. Corporate bond holders tend to get paid first in the event of bankruptcy, and sovereigns need not default if they can print their own currency.
However, in attempts to quantify and limit risk through quantitative models, it has become the case that when people talk about equities being more risky, they often simply mean more volatile. Many have discussed the flaws in this view; why should the daily, weekly or monthly volatility of returns matter if you are planning to invest over the long term?
Volatility can certainly feel like risk on a one year view. The S&P 500 lost 43.8% in 1931, 36.6% in 2008 and 22.0% in 2002, and I think it is fair to say that it is these crashes that investors are really worried about, rather than volatility per se.
With a longer time horizon though, the S&P 500 would have delivered a positive return for almost every period in recent history. The chart below shows 1 year, 5 year and 10 year subsequent annualised nominal returns from investing in the S&P 500 in a given year (so, if you had invested in 1928 at the start of the chart, you would have received around 40% over the following year, -13% annualised over the next five years, and been close to flat over the next ten).
Despite this painful starting point, there have only been 5 years since 1928 from which a 10 year investment would have lost you money (3 at the start of the Great Depression and 2 capturing both the early 2000s recession and the Global Financial Crisis of 2007-08). Moreover, you can see that the variation in the range of outcomes becomes far narrower as time horizon is extended.
It is also the case that you tend to be rewarded for tolerating short-term volatility. Over a multi-year period, the short-term volatility matters less to the return outcome you experience, but the risk premium remains very relevant. Equities have outperformed bonds for the vast majority of 10 year periods since 1928 (the returns below are before inflation).
Academics have puzzled over why you should earn this extra return, but the answer seems intuitive; investors become overly worried about the short term and leave ‘returns on the table.’ A paper published in August seemed to bear this out; the authors found that in a ‘field experiment’ professional traders who received less frequent price information tended to hold more in risky assets and earned higher profits than those with more regular pricing updates.
Bring me the horizon:
What then are the implications for asset allocation? The simplistic observation is that equities appear generally to offer superior returns to investors that are willing and able to tolerate some price volatility.
But this should always be caveated by an observation on valuation, on which the long-term return outlook of any asset is contingent. The equity risk premium hit 0 in the US in 2000 so the subsequent disappointing returns can’t be altogether surprising (see figure 4). This is a far cry from the elevated risk premium of around 6.5% on offer today.
These charts illustrate the argument against volatility aversion, and even against ‘crash aversion.’ An excessive focus on short-term price moves can deter investors from seemingly riskier assets that would in fact deliver preferable return outcomes over a horizon that’s relevant to them. Defining the “riskiness” of an investment by its volatility over other periods is somewhat missing the point.
This is why we prefer to think of risk as the potential for permanent capital loss and seek to maintain a long investment horizon and avoid getting too caught up in short-term price volatility. Through the lens of this framework, assets that are traditionally viewed as “safe” or “risky” can in fact appear to be quite the opposite.