Volatility and risk: Take the long-term view

It is well known within investment parlance that a key way to reduce the risk of investment in areas such as Equity markets is to take a long-term view. With greater volatility within markets, particularly as a result of central bank intervention over a prolonged period, the timescale over which the ‘long-term’ view is taken would seem to have stretched from say 5 years to 8-10 years and beyond.

By Jason Street, Taylor Patterson Financial Planning.

Indeed, one of the most famous investors in the world, Warren Buffettt, believes in buying quality businesses and holding them for 50 years! Certainly a long-term view in anyone’s language.

What is clear is that a greater understanding of what Volatility and Risk within investment markets actually mean, could go a long way to potentially reducing the reactions of some investors to shorter-term news flow and market gyrations, leading to a more balanced approach to long-term investment.

The ‘volatility’ of a stock or fund, within investment markets has to do with the measurement of the regular and sharp fluctuations in value that are seen, the ups and downs as it were, or the rollercoaster ride, depending on the area of investment!

The ‘risk’of an investment has to do with the risk of permanent loss of capital, which could equally have to do with, for example, the security of a bank or the size of the business into which investment is made, not just the ups and downs of its share price. There are important differences between an investments volatility and its risk.

The volatility of an investment should be a concern to an investor if the money is likely to be needed in the near term (perhaps less than 5 years). But just because an investment is more volatile does not necessarily mean it is more risky in the long-term. As the time horizon for holding an investment gets longer, the effect of volatility is reduced. The stockmarket as a whole is obviously more volatile than a bank deposit, but that does not mean that investors should necessarily bypass an investment in the stockmarket altogether. Instead it means that investors should know the potential for short-term volatility to offset the value of their investments and plan accordingly.

A further consideration is an investors ‘capacity for loss’. An attitude to risk can be subjective, whereas this contrasts with an individual’s capacity for loss, which is objective, ie: it can often be more readily measured and can vary over time. Whilst an individual’s attitude to risk may not change, their capacity to bear loss may do so as their circumstances alter, such as a capital injection from the sale of a business, or receiving an inheritance. The capacity for loss of an individual therefore refers to an individual’s ability to absorb falls in the value of their investment and if this loss were to have a material effect on their standard of living.

All such factors should be taken into account when constructing a well thought through financial planning and investment strategy. Our discussions around risk, volatility and capacity for loss provide the cornerstone to our financial planning and investment management processes, providing an understandable and well-conceived outcome for our clients.

Warren Buffett quotes; ‘Volatility is not the same thing as risk, and investors who think it is will cost themselves money’. Given his success over many decades, we would be wise to heed his advice!