Understanding Risk – Volatility

Date: January 23, 2014

When we hear or read the term “risk” it is predominately perceived as negative or something to be avoided or a threat that we hope will not materialise. Risk is a fundamental part of life. It exists because we are uncertain of the outcome of a particular decision or course of action. There is always a certain degree of risk in any decision we make concerning our life, career and, of course, financial choices. In investing, however, risk is inseparable from performance. Rather than being desirable or undesirable, risk is simply necessary. Understanding risk is one of the most important aspects of financial education and we would be foolhardy to ignore its existence, especially when it comes to investing.

What is investment risk?

Simply put, investment risk is a deviation from an expected outcome. For example, the average annualised return for the STI is approximately 10% per annum. But it does not do so in a linear manner and there are ups and downs. Risk is usually expressed in absolute terms or relative to something like a market benchmark. In Singapore, the Straits Times Index (STI) is the market benchmark and represents the top 30 companies by market capitalisation and in the US, it is the Dow Jones Industrial Index.

Table 1: Yearly return of Straits Times Index

     Year   Beginning Price   Ending Price   Gain or Loss   Percent Gain or Loss
1988 823.30 1038.60 215.30 26.15%
1989 1038.60 1481.30 442.70 42.62%
1990 1481.30 1154.80 -326.50 -22.04%
1991 1154.80 1477.00 322.20 27.90%
1992 1477.00 1524.40 47.40 3.21%
1993 1524.40 2425.70 901.30 59.12%
1994 2425.70 2239.60 -186.10 -7.67%
1995 2239.60 2266.50 26.90 1.20%
1996 2266.50 2216.80 -49.70 -2.19%
1997 2216.80 1529.80 -687.00 -30.99%
1998 1529.80 1392.73 -137.07 -8.96%
1999 1392.73 2479.58 1086.85 78.04%
2000 2479.58 1926.83 -552.75 -22.29%
2001 1926.83 1623.60 -303.23 -15.74%
2002 1623.60 1341.03 -282.57 -17.40%
2003 1341.03 1764.52 423.49 31.58%
2004 1764.52 2066.14 301.62 17.09%
2005 2066.14 2347.34 281.20 13.61%
2006 2347.34 2985.83 638.49 27.20%
2007 2985.83 3482.30 496.47 16.63%
2008 3482.30 1761.56 -1720.74 -49.41%
2009 1761.56 2897.62 1136.06 64.49%
2010 2897.62 3190.04 292.42 10.09%
2011 3190.04 2646.35 -543.69 -17.04%
2012 2646.35 3167.08 520.73 19.68%
2013 3167.08 3167.43 0.35 0.01%

Note: the above does not include dividend                 (Source: www.1stock1.com)

Chart 1- Dow Jones Industrial Average:

(Source: Yahoo Finance)

Looking at the US market, historically, if we invest in the Dow Jones Industrial Average (DJIA), the probability of getting a positive return, based on returns from October 1928 till now, is as follows:

(Source: 3 Dimensions of Successful Investing)

Referring to the table above, based on the high probabilities of return, the DJIA seems to be a very good investment. Does this mean that you will get a positive return as long as you hold it for the long term?

Let’s look at a recent example: if you had invested in DJIA in 2008, you would have made a huge loss of 50% of your investment capital in just one year. Four years later, you will still be making a negative return.

If you are investing in the Straits Times Index (STI), the probability of getting a positive return, based on returns from December 1987 till now, is as follows:

(Source: 3 Dimensions of Successful Investing)

The probability of a positive return over each horizon is smaller than DJIA, but there is still a 75.2% probability of positive return for a 10 year investment horizon. Furthermore, you will not be exposed to foreign exchange risks that may erode your returns in the long run, which is yet another risk that one needs to take into account when investing overseas or in foreign currency.

In both the US and Singapore equities market, the probabilities of a positive return increases over time and thus it is important to also understand and determine one’s investment time horizon.

From the above examples, we can see that the deviation can be positive or negative, and relates to the “no pain, no gain”, that is, to achieve higher returns in the long run you have to accept more short-term volatility. How much volatility depends on your risk tolerance – which is an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short term losses.

Happy investing.

Richard Christopher Dyason

Richard is the General Manager at SIAS and previously Vice President at SGX. He has over 13 years of experience in various management positions in the financial services and over 25 years of management and consulting experience. He has been a trainer for several organisations and he is passionate about investment training and educating investors and has spoken at many SIAS, industry and public events.