Share prices are relatively volatile compared with cash in the bank or fixed-income securities and this can be disconcerting to some investors. Volatility is caused by company-specific or economy-wide events that can make investors re-assess the long-run earnings outlook for companies, which in turn affects their share prices.
Due to the irrational passions of fear and greed, these re-assessments are also often over reactions – this can cause large share price movements in the short-term, which are then at least partly corrected later. In 2008, for example, the Australian MSCI equity index lost 40% in value, with dividend returns limiting the overall loss to 37%. This followed the three “boom” years to 2006 in which the market produced annual returns of more than 20%. In 2009, the market rebounded, returning 39% while returns in 2010 were flat.
Over the past 20 years, the standard deviation in annual returns was 18%. Assuming 8% long-run returns, and the same level of annual volatility, this implies that there is roughly two-thirds of a chance returns will be between 26% and minus 10% in any given year.
Five ways to minimise risk
Share risk can be reduced, but not eliminated, in several ways.
The simplest and most effective form of risk mitigation is diversification. Generally speaking, the share price of an individual company is more volatile than that of the industry sector it is in and, in turn, the performance of industry sectors are more volatile than that of the overall market.
By buying a collection of stocks – or exposure to an overall sector or the market, through, say an exchange-traded fund (ETF) – the year-to-year volatility or returns may be reduced without necessarily reducing your expected long-run investment return. Diversification is best achieved by finding stocks with similar long-run expected returns, yet quite low correlation in returns in any given year. This is possible by investing in shares in different industry sectors, countries or regions.
By lowering risk without lowering returns, diversification is sometimes called “the only free lunch” available in investment markets.
2. Fundamental Research and Valuations
For those with the time and skill, risk can also be reduced through diligent research into a company’s fundamentals or the share market overall. Both the market and individual shares go through cycles of under and over-valuation and understanding these cycles can help you manage your investments. One strategy that tracks a cycle is represented by the mantra: “Buy low, sell high.” By buying when prices appear relatively cheap – and avoiding too many stocks when valuations are expensive – you can limit the risk your shares will lose value in the long run.
There are various ways to assess value at both the market and individual company level. One popular measure is the price-to-earnings ratio commonly known as the ‘PE ratio’. The higher stock prices are relative to earnings, the pricier the stock or overall market. There are various measures that can be used to track earnings, including one-year historic or one-year forward expected earnings, and even the long-run trend or ‘cyclically adjusted’ earnings.
Another valuation measure is the price-to-book value, which has the advantage that book values are generally less volatile than earnings over time. Book value is an accounting concept that measures the balance sheet value of a company’s net assets.
3. Stop Losses
For more active investors and traders, capital management through the use of stop losses can also be useful. A stop loss is a pre-determined price at which you commit to selling a share to either capture profits or minimise loss. The stop loss is locked in by your broker or online broker and automatically triggered when or if the stock reaches that price. Pre-determined stop losses can be useful to guard against the classic investment mistake of holding onto losing investments for too long, hoping share prices will eventually bounce back.
4. Long-term Perspective
Another way to deal with risk, depending on your investment goals, is to focus on the long term. For investors with a five to 20 year investment horizon, for example, month-to-month or even year-to-year volatility in the share market should not matter because shares should eventually rebound in line with economic growth.
In the four five-year periods since 1990, for example, annualised returns have been 15.7%, 10.5%, 12.7% and 4.5% respectively, implying a standard deviation of only 4.7% with no negative returns. Indeed, it is very rare for the Australian market to produce negative returns over a five year period, much less 10 or 20 years.
5. Asset Allocation
Many investors minimise risk in their share portfolio by buying shares in different sectors of the share market. For investors with relatively short-term investment horizons or where a steady stream of income is important – such as in or close to retirement – risk can be managed through appropriate asset allocation. This involves holding less of one’s investment portfolio in volatile shares, which could suffer short-run losses, and more in lower return but less volatile cash or fixed-interest investments.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.