The real risk to your investments…

…is your own investment behaviour. That’s how I choose to interpret what Charlie Munger, Vice-Chairman of Berkshire Hathaway Corporation says, of risk and volatility, in their much looked-forward to annual newsletter to shareholders.

In his words “If the investor fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things”.

Yet, when we measure the swings in your fund performance using metrics such as standard deviation, we do attribute such volatility to risk. So are we making a mistake?

Not really, because in the short term – volatility hurts portfolio returns. When the Buffetts and Mungers talk of volatility not being synonymous with risk, the underlying assumption is that you have a multi-decadal view of the equity asset class and that you do not enhance the risk by your own erroneous investment behaviours.

That essentially means that the problem is not with the volatility or the seeming risk associated but with the investor’s outlook and expectation of the equity market.

Here are a few issues with the way we perceive equity markets and also in the way we invest

 Short-term outlook

The first and foremost problem is with our short-term outlook. If you in the equity market for the short term, yes, volatility counts simply because equities are far riskier when you hold them for a few weeks, months or even a year. Just to illustrate, take the case of an outperforming fund like ICICI Pru Vale Discovery.

Its volatility, measured by standard deviation is 11.3% for any 3-year returns (based on daily rolling data for last 5 years). That means it can deviate from its mean returns by 11.3% – on the upside as well as downside. However, for the same fund, if you take the standard deviation of its 1-year returns (again seen on a daily rolling basis over the last 5 years) it is as high as 36%.

That means, its returns can swing 36% up or down from the average returns. So you can lose a third of the returns as a result of volatility!

Clearly, the longer the period, lower the standard deviation; to a point where volatility is no longer risk and is something that normalises with time. This is what Charlie Munger suggests when he says volatility is not synonymous with risk.

“For the great majority of investors, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime”

Timing the market

For many Indian investors, investing is a one-off, sporadic activity and not seen as an ongoing one, done over time. This, combined with the short-term outlook means the risk of timing the market. Hence as Charlie puts it, by their own behaviour, investors make equity investing far riskier than it is.

An investment done in the peak of 2008 for instance, would have hardly delivered even 3-5 years hence; thanks to ill-timing the market. However, the same investment, spread over time – say through SIPs would still have delivered decent returns, in fact, taking advantage of the same volatility that seemingly pulls down returns.

A long-term view combined with investments made over time, would be the best recipes to completely neutralise volatility in your portfolio.

 Lack of diversification 

The stress of seeing your portfolio swing wildly can be largely mitigated when you diversify your portfolio – diversify across asset classes, across categories and across styles of investing. Ever wondered why most of us fail to diversify? It stems from the wish to chase returns.

Running behind an asset class that delivered superlative returns or filling a portfolio with a theme that recently outperformed (and perhaps lost steam) are some of the reasons why volatility hits your portfolio. Many investors who went overweight on gold at its peak in 2012 would have taken a hit in the next few years; similarly with gilts in the same period.

Diversifying helps reduce volatility and removes the need to time asset classes or fund classes at different points in time.

In Charlie’s words:

“Investors, of course, can, by their own behaviour, make stock ownership highly risky. And many do. Active trading, attempts to ‘time’ market movements, inadequate diversification…. can destroy the decent returns that a life-long owner of equities would otherwise enjoy”. 

The lesson is simple: change your outlook – change the way you view equities as an asset class, diversify, buy over time and forget what market forecasters say.

And Charlie ends with this piece of quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”