The two sides of volatility risk for investors

MANY economists and financial analysts expect a turbulent and volatile investment market this year, so I thought I’d revisit the subject of investment volatility.

Volatility is a statistical term describing the extent to which the value of an investment fluctuates over a given period – in short, how bumpy the ride is for the investor. Investopedia puts it thus: “Volatility [in this context] refers to the amount of uncertainty or risk related to the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time in either direction. A lower volatility means that a security's value does not fluctuate dramatically, and tends to be more steady.”

Volatility applies to individual securities, but it also applies to market indices, which measure baskets of securities, and to the investment portfolios of collective investment schemes, such as unit trust funds.

The higher the volatility, the steeper and more severe the ups and downs endured by investors – like those on the main-attraction roller-coaster ride at the fairground in contrast to the gently undulating ride of the scaleddown kiddies’ version.

An example: The share price of Company A starts the year at R10. Over the course of the year, its low point is R9 and high point is R12, but it finishes the year at R11 – an increase of 10%. Company B also starts at R10 and also ends the year at R11, but with wild swings in-between, dipping as far down as R6 and soaring as high as R15.

For an investor buying at R10 and selling during the year, the most he could lose on his investment in Company

A would be 10% (selling at R9) and the most he could make, if his timing was perfect, would be 20% (selling at R12). If he’d invested in Company B, the most he could lose would be 40% (selling at R6) and the most he could make would be 50% (selling at R15).

So Company B is obviously the more volatile share for the investor, and more risky, even though both end up making the same returns over the year.

Popular asset classes, in ascending order of volatility risk, are:

1. Cash: zero.

2. Bonds: mild.

3. Listed property: moderate. 4. Shares: high.

5. Cryptocurrency: through the roof.

Among shares, some are more volatile than others, for many reasons. As a general rule of thumb, large, well-established companies are less volatile than smaller, younger ones.

Measures of performance versus volatility

In 1966, American economist William F Sharpe introduced what he called the reward-to-variability ratio, later called the Sharpe Ratio, which measured the returns of a security or index over a given period against its volatility, using a benchmark of what a risk-free return would give you. The risk-free benchmark would typically be the interest rate of a government bond or a money-market rate.

The formula is: the return of the security minus the risk-free rate, divided by the standard deviation of the security’s returns. (Standard deviation is a statistical measure of variability/volatility.)

The higher the Sharpe Ratio, the better the return taking volatility into account – this is known as the risk-adjusted return. Going back to our example above, it’s clear Company A would have the superior risk-adjusted return.

The Sharpe Ratio has been more or less superseded by the Sortino Ratio, named after another investment whizz, Dr Frank A Sortino, which takes only downside risk (volatility below the mean) into account – after all, any volatility to the upside (above the mean) is to your benefit as an investor.

Volatility in local funds

Looking at unit trust funds that invest primarily in shares on the JSE (South African Equity General category), over three years to the end of 2022, the Sortino Ratios range from a very healthy 1.68 to a dismal -0.5 (a negative result meaning that the return was below the risk-free return, in this case, the three-year bank acceptance rate).

The Sortino Ratio is one factor used in the assessment of actively managed unit trust funds for the Raging Bull Awards, which will be presented on February 28. The awards for risk-adjusted performance are determined by the Plexcrown Fund Ratings, which assesses performance over five years. Among the measures the Plexcrown Ratings takes into account, is the Sortino Ratio.

A note on risk

While a fund, index or security that delivers a certain return at lower volatility is preferable to one that delivers the same return at higher volatility, the risk associated with volatility should not be shunned outright. A certain amount of risk is necessary to boost returns over the long term, bearing in mind that volatility “smooths out” over longer periods.