29 Apr 2019

Defining risk

"Charlie and I would much rather earn a lumpy 15 percent over time than a smooth 12”  - Warren Buffet

It has been a volatile time for global equities recently.   In the space of only four months the US S&P 500 Index, one of the more volatile equity indices over that period, has been down as much as 19% from its highs and up as much as 15% from its lows.

Standard financial theory equates volatility to risk.  The more volatile an investment's return, the higher its risk. This is a fundamental premise of Efficient Markets Theory and Portfolio Theory, the theoretical foundations of most orthodox investment portfolios. But how important should volatility be? The answer depends on your investment horizon.

Listed equities are one of the more volatile investments in the short-run, but over the long-term they have proven to be one of the more productive generators of wealth.  This is because more volatile investments require a higher return over an average investment period to compensate for this volatility.  Investors with a long investment horizon can benefit substantially from the compounding effect of these returns, which will ultimately outstrip any effects of short-term volatility.

We recommend a 5-year minimum investment period for our equity funds, which is not unusual.  The table below shows the return from the S&P 500 over 5-year periods since 1988, and the maximum monthly negative return in each period. While the negative month returns generally appear small compared to the accumulated 5-year returns, those negative months would have undoubtedly been traumatic and painful periods for someone investors and might have even caused some to sell their portfolios. 

In our opinion, a far more important risk is the risk of permanent loss of capital. The average holding period of a listed company for the market is estimated at less than 1 year. If you expect to sell within a year the high volatility of equity prices can certainly equate to permanent loss of capital, but if your investment horizon is longer you can wait out this volatility and begin to benefit from the compounding of higher returns over a long period.  Permanent loss of capital can be avoided in two ways. The first is through sensible diversification of investments. Second is through careful examination of the company's assets and liabilities that you invest in.

In our opinion, when investing in listed companies, volatility is your friend.  Provided you safeguard against a permanent loss of capital it provides a long-term compounding return tailwind, and provided attention is taken to permanent loss of capital, periods of high volatility can throw up wonderful long-term investment opportunities.