What's investment volatility?

Understand investment volatility and how to ride the ups and downs of the investment market.

By John Lawson

When we talk about investment ‘risk’ we usually mean investment volatility. For example, when people ask, “what’s the risk my investments might fall 20% or more?” they want to know how volatile the market is.

While other risks such as insolvency risk and credit risk could impact your investments, here we will look at volatility: – whether you can reduce it, and if so, how you go about doing that.

Can you wait it out?

Depending on how long it is until you need your money back (sometimes referred to as your ‘investment horizon’), you may be prepared to accept more volatility if it means you could get a better return.

An example of investors who can accept greater volatility in the hope of being rewarded with better returns, are pension savers under 45. With at least a decade until they can legally access their savings and, more realistically, 20+ years before most of them do access their savings, this should provide enough time to ride the ups and downs of investment markets.

Despite this, there’s no guarantee that this will be true in the future. In addition, one of the conditions that investors must accept when investing in equities is higher volatility in the value of their investments. 

For example, on 19 May 2008, the FTSE closed at 6,376. By 3 March 2009, it had fallen to 3,512 – a fall in capital value of 45%. However, by 15 April 2010, it had risen back to 5,825, a 65% increase above the 3 March 2009 low point.

Controlling volatility

If you’ve invested for the long-term and don’t need to access your savings, it’s possible to tolerate this level of volatility.

But if your investment horizon is shorter, or if you access your savings regularly, then you need to think about how you can control volatility. For example, an investor who is taking withdrawals from their pension can do irreparable damage to their savings if they continue to draw income from investments that have markedly fallen in value.

There are three main ways to reduce volatility:

1. Diversification

Diversification simply means spreading your eggs. This can be done in a number of ways.

You could diversify within one asset class. For example, if you are investing in shares, you could invest some of your money in shares that tend to do well in a rising market, such as the shares in construction companies. You could invest the rest of your money in shares that tend to do well in a falling market (sometimes called ‘defensive stocks’) such as utilities or food retailers.

Another way to diversify is to invest in different sorts of assets. So, instead of investing all your money in equities, you could invest some in bonds, some in commercial property and some in cash. This means that if one type of investment doesn’t do well, the overall impact is offset if the other investments perform better.

You can either diversify yourself by picking a number of different investments or you can leave it up to an investment manager to do this for you. Funds that invest across a number of different investment types or ‘asset classes’ go by a number of names such as ‘balanced managed’, ‘diversified growth’ or ‘multi-asset’.

These diversified funds also come in a different range of prices depending upon whether the underlying single asset funds that make up the overall fund are passive (index-trackers) or active funds. There is therefore a wide range of prices for these funds ranging from 0.2% to over 1.5% per annum.

Regardless of what fund you invest in, check that the performance net of charges has delivered acceptable returns historically, as there is no direct link between price and performance.

OCF evidence (Aviva Manager of Manager funds – most expensive diversified asset funds) 

Vanguard Life strategy funds (amongst the cheapest diversified asset funds as use passive components) 

2. Hedging

Another way to decrease volatility is hedging. Hedging simply means that the fund manager takes insurance against the value of their investments falling or against the possibility of missing out on a rise in the value of an investment. Investment managers might also hedge against things like currency exchange rates or a change in interest rates impacting the value of their investments.

The most common way to hedge is to use derivatives. These are financial insurances that allow an investment manager to buy or sell assets such as equities and bonds at a known price at some point in the future.

For example, if the manager had invested in the shares of companies in the FTSE 100, but thought there was a risk that the value of those shares might fall, they might buy an option (a type of derivative) that allows them to sell those shares. If the FTSE 100 today was, say 7,200, but the investment manager feared that it might fall sharply, they could buy an option to sell their shares at a value of say 7,000 in a year’s time. If at the end of the year, the FTSE 100 stood at 6,000 (a fall of 17% from its current value) the manager could use their option to sell at 7,000 (a fall of less than 3% from its current value), thus limiting the loss. If the FTSE 100 was above 7,000 at the end of the year, then the option is worthless as they could sell the shares at a higher price.    

Derivatives contracts cost money and that extra cost will affect investment performance. It also means that the charge for such funds is usually a bit higher than average.

Names like ‘absolute return’, ‘multi-strategy’ or ‘target return’ are used to describe funds that use hedging strategies. Many of them have an objective to deliver a certain return, such as Bank of England Base Rate plus 5%, over a rolling fixed period of say three years. However, there is no guarantee that these funds will achieve the return set out in their objectives and the capital value of your investments might fall.  

Expect to pay around 0.75% upwards in charges each year.  

3. Smoothing

Smoothing involves holding back some of the returns earned during periods of good performance and using those to reduce losses during periods of poor performance.

This is the basic principle under which with-profits funds are managed. While older with-profits funds include guarantees that your fund will not fall in value or even increase by a set percentage each year, more modern versions do not include these guarantees. That means your investments can fall in value, but hopefully the smoothing will cushion the fall. 

A newer type of fund – usually called ’smooth managed’ uses a set formula to smooth returns. This is similar to the more modern versions of with-profits and again, the fund can fall in value.

Expect to pay around 0.7% a year upwards for this sort of fund. 

The value of investments can go down as well as up and you could get back less than invested.