The terms ‘risk’ and ‘volatility’ are very often used together and when used in context make absolute sense. For example one could say the higher the volatility, the riskier the security, which is perfectly reasonable to describe the volatility of a particular security in the context of how ‘risky’ the security would be viewed. However, more often when referring to retail investments the term risk is used in isolation when in fact volatility would be more appropriate.
Which of the following structured products is ‘riskier’?
1. A structured investment offering a fixed return of 50 per cent if the FTSE100 is greater than its start level over a five-year period. Capital is at risk if the final level of the index is lower than 50 per cent of its starting level; or
2. A structured deposit with a six-year term offering performance linked to three underlying indices with capital fully protected up to FSCS limits.
Clearly the answer is dependent upon how much capital the client is prepared to lose. In simple terms they will not lose anything with the structured deposit but clearly there is potential to lose capital with the investment plan. Arguably however the structured deposit offers a more volatile pay-off profile.
The term ‘volatility’ when relating to an investment describes the movements around a given benchmark return over time for that particular investment. For example, a UK equity investment fund may use the FTSE 100 index as its chosen benchmark therefore the volatility of that particular investment would be a relative measure of the dispersion of returns around the FTSE 100 over time.
This is very different to ‘risk’ which should always be considered as an absolute measure of how much capital an investor is prepared to lose, not by how much their investments will go up and down over time.
‘Risks’ are absolute and take many different forms for example, investment or market risk, interest rate risk, credit risk, inflation risk, currency risk and so on. Retail customers when assessing their attitude to risk should ask themselves the question, how much capital am I prepared to lose? The answer to this question should of course inform the adviser or portfolio manager how to construct the investment portfolio in line with the customer’s stated objectives.
Investments that display high volatility can often be used for a low-risk investor within a well-constructed portfolio provided the overall balance of the portfolio is mapped within the investor’s risk tolerances. The same of course can also be true of high risk investors using investments exhibiting low volatility. The blend of these investments is what is important which is where diversification becomes important.
To diversify is defined as becoming more diverse or varied; the real skill is doing it in an appropriate and efficient way of course and in line with the wider risk parameters agreed with the client. Having said that, ignoring short-term volatility within an investment portfolio is a very easy thing to talk about, however, in practice, can be difficult to ignore. Considering the annualised volatility of the FTSE 100 over the past 10 years it is clear to see that there have been some significant movements over this period, but for the majority of this term volatility has remained below the 10-year average.
It is important to remember, first, that volatility is the price an investor pays when looking for investment returns over and above the risk free rate, let’s assume that’s cash, and second, it seems almost trite to remind ourselves that volatility is of course, volatile.
Short-term volatility has rarely caused problems except where panic manifests itself into negative investor sentiment creating an almost emotional hysteria where individuals move from (apparently) risk tolerant investors to risk averse, even though their respective attitudes to ‘risk’ have remained relatively stable. The assets that they are invested in haven’t changed, however, market volatility has perhaps widened the range of returns around the expected benchmark giving the psychological impression that they have in some way become more ‘risky’.
The very nature of a structured product’s defined pay-off and defined downside protection can help investors manage risk and volatility within their portfolios. With defined upside often contingent upon a market movement either up or down, structured products can help mitigate a portfolio’s volatility when added to traditional investments with variable upside. Capital protection of course is the obvious benefit afforded by structured deposits that can help mitigate downside risk.
Financial markets are extremely delicate and often move in directions paying little notice to fundamental drivers (arguably already priced in we are often told) however when sentiment, either positive or negative, takes hold we are often left watching bull or bear markets take effect with little or no real explanation.
Investing is a “risky” business, hence why investors should be clear and resolute in what they are buying and why, and more importantly what they hope to achieve.
Gary Dale is head of intermediary sales at Investec