What is risk and volatility?

There are risks associated with any investment. Risk is associated with returns, which implies that investments with the highest return potential also typically have the highest risk of loss. Additionally, safe investments usually yield lower returns. Risk involves the possibility of suffering a loss. If you are globally diversified, the chance of experiencing serious losses is less. However, you almost certainly will experience volatility.

Risk is frequently misunderstood by investors as volatility. Volatility is referred to as the price movement, the more dramatic the price changes, the more volatile and therefore referred to as the riskier the investment. The risk could be referred to as the possibility of not meeting financial goals. Volatility is referred to as a 1% plus or minus movement in price. Therefore, owning an extremely volatile investment that has only gone up is technically possible (albeit unlikely).

To put this into perspective, stock prices move every day due to market forces (supply and demand). To measure a stock’s volatility relative to its benchmark, we use its beta. Beta will approximately measure the volatility of a stock’s return against its benchmark. If a stock has a beta of 1.1, it means it will move 110% for every 100% movement in the benchmark. On the other hand, if a stock has a beta of 0.90, it will move 90% for every 100% movement in the benchmark. This can be found on any stock’s financial summary page. Stocks tend to be volatile, as short-term noise can affect market forces which affect the stock’s price meaning price swings can occur daily.

For stock markets. Take the S&P500 as an example between 1999 to 2019, 70% of all trading days moved on average between ±1%. This shows most of the time, the S&P500 is regarded as less volatile an individual stocks. 20% of the time the stock market moved ±2% and 10% of the time, the stock market moved ±3%.

Comparing a stock versus a stock market is not comparable, but it illustrates the need for diversification when it comes to spreading your risk, as a single stock is more likely to fail than a whole index.

 

Investment types according to their risk and potential return

Given that risk and return are correlated, we can rank different investment types for their risk and return. In the example below, we will be looking at the risk and return for fixed income and equity:

 

• Money markets or government treasuries (Fixed income)

One of the ways (but not limited) to measure risk in fixed income is its default risk. This is the risk the borrower may not pay the lender back. T-Bills in the US or GILTS in the UK are often lower risk due to their low default risk. Developed governments tend not to default on their payment of fixed income, and this is reflected in their bond rating by rating agencies. The rating agencies evaluate all different bonds to help gauge default risk.

 

• Investment-grade corporate bonds

Rating agencies separate fixed income into two major categories: investment grade and non-investment grade. Firms such as S&P Moody’s and Fitch adopt distinct designations, which are made up of the capital and lowercase letters “A” and “B,” to indicate the credit grade rating of a bond. The use of A’s and B’s are considered investment grade whereas C’s tend to be considered lower credit quality and are referred to as junk bonds.

Corporate bonds tend to be higher risk than government-issued bonds, as they pose a higher default risk as companies are more likely to default than governments.

Issuers of bonds are one characteristic of bonds. You can buy different bonds according to their maturity (how long they make payments to the lender), different currencies, or buy a basket of bonds through a bond index.

Did you know, David Bowie issued bonds which were sold to bondholders who were entitled to receive part of his royalty income?

 

• Large-Cap Equity

Also known as blue chip stocks, are large corporations, with financially sound balance sheets. Equity is riskier than fixed income as there are no guarantees. Buying single stock companies exposes you to losing all your initial capital as the company may go bankrupt. Large-cap companies tend to have a lower default risk than other equities as they are well-established and should generate enough revenue to show a profit. This in turn may result in consistent dividend payments to investors, as a thank you for investing your initial investment into their company.

An easy way to lower your risk is to spread your investments. Buying multiple stocks can lower your risk by investing in a basket of funds through an index fund. You don’t have to buy thousands of stocks yourself, you can achieve this through an index fund. Read more about it here.

 

• Small-Cap Equity

The Wolf of Wall Street depicted Jordan Belfort selling Aerotyne, a ‘penny stock that had huge upside potential with very little downside risk’. Unfortunately, small-cap equity, including penny stocks may have higher returns, potentially more than large-cap equity, but it does come with higher risk. With equity in general, they are subject to short-term fluctuations, or volatility. This extra risk means investors are compensated with a higher return over the long run.

Small-cap equity has a general misconception that they are all start-up companies or new companies. They could well be established businesses just like large-cap companies. They have a smaller market capitalisation in their respective stock markets. Due to their lower size and higher growth potential, small-cap companies have historically performed better than large-cap companies.

 

• Emerging Market Equity

Companies which are located in emerging countries such as Brazil, China and South Africa fall into this category. Hong Kong is a developed market and therefore would not form part of this group. This doesn’t mean Hong Kong stocks are not risky but for category purposes, emerging markets tend to be riskier due to political instability and liquidity. There aren’t as many buyers and sellers in emerging markets therefore broker fees (the middleman) are higher to cover the price uncertainty as they have to find a counterparty to trade with.

Evidence-based financial planners in Hong Kong may use ‘tilts’ in their portfolios. Which means slightly higher exposure to one or more of the higher expected returns as shown on the graph. At Private Capital, our investment philosophy focuses on data-driven portfolios with an emphasis on characteristics that have been empirically proven to capture premiums that the stock markets undervalue. To learn more about this, read our investment philosophy here.

 

Risk Tolerance

Your risk tolerance determines how much volatility or uncertainty you can handle within your investments without feeling uncomfortable. Two factors which determine your risk tolerance are your asset allocation to equity and fixed income:

• Investment timeline
• Risk appetite

Your timeline is when you will need to access your money. The longer the timeframe, the more risk you can take on.

Risk appetite is how much risk you can handle. You’ll most likely have a lower risk tolerance if you panic during periods of extreme market movement or volatility. However, you might have a higher risk tolerance if you can ride out the volatility. Understanding your risk is crucial to achieving your investment goals. Misalignment can cause unnecessary stress and could lead to behavioural changes in your portfolio (higher trading).

If you would like to gain more clarity on your risk tolerance and how it influences your investment choices, consider completing a risk tolerance questionnaire. Contact us today to answer the questionnaire and receive personalised insights into your risk profile, helping you make informed investment decisions that suit your financial objectives and comfort level.