Date: February 6, 2015

Market volatility returned to the Australian sharemarket during the second half of 2014, which after a number of years of positive market performance, served as a reminder to investors that share prices can move in both directions.

To the end of December 2014, the S&P/ASX300 accumulation index endured a poor quarter as the weakness in oil prices triggered some concerns about the state of global economic growth. In the previous month, the Australian sharemarket recorded a one-year loss of -0.4% p.a. with the All Ordinaries Index having declined by more than 83 points on Friday 28th November 2014. a drop of 1.6% in one day. However, this trend was short-lived as the market largely shrugged off these worries in the latter half of December to post a 2% gain for the month, ending the year in positive territory and thus reinforcing the need for investors to expect (and embrace) market volatility once again.

The foundations of Risk and Return

Risk is integral to investing. This can be a frightening thought, but risk shouldn’t necessarily be feared, as without it there is less opportunity for reward. Quite simply, the higher the return you want from your investments over a particular period, the more short-term volatility (or risk) you have to accept in the value of your investments. Granted, if you’re happy to receive the bank deposit rate, currently at historically low levels in Australia, you can put all your money in the bank, safe in the knowledge that the account balance will rise a small amount throughout the year. But if you want higher returns, you’ll have to take on more risk and consider other investments, such as shares, fixed income, commodities and property.

Accepting short-term volatility for higher returns

Why do some investments offer higher returns than bank deposits? Each investment has different characteristics and offers varying potential levels of return. For example, a share’s return over a particular period is uncertain as the company’s profits are unpredictable, therefore share owners require a greater return than they would accept from bank deposits. What share investors are implicitly saying is “I want a higher return, but understand that I have to accept volatility in returns over the short term”.

Looking at risk from a longer-term perspective

Risk is the possibility or probability of loss. But if you’re talking about one of those frequent falls in a share price on a particular day, is that really an important loss? Firstly, it’s only a loss if you sell the investment. Secondly, most of the time these paper losses are temporary and prices soon bounce back; this is the usual volatility of the stock market. The reason this is important is that the financial industry has defined an asset’s risk as the extent to which its price fluctuates; in other words, risk is the likelihood of an asset not achieving its long-term expected return over a short period.

Perhaps the risk that you should really care about is the possibility of an asset not achieving its expected return over the long term, rather than over the short term. In the case of shares, such a situation might arise if the company in question goes out of business. So important risk relates to permanent loss of capital, not day-to-day losses of which the vast majority are temporary. Instead of thinking of volatility as a risk (and therefore something to be concerned about), think of it as the cost of the longer-term return. And, if you’re able to ignore the fluctuations in the value of your investments from day-to-day and month-to-month, it’s a cost you won’t notice.

Diversification is a fundamental principle of investing

Avoiding permanent loss of capital requires careful analysis of the investment/s in question. You can reduce the impact of permanent loss by diversifying your portfolio across a number of shares, managers and even across asset classes. For example, a simple multi-asset portfolio could include shares, property, government bonds, corporate bonds and cash. Given each asset class has its own expected return, they can be combined in different ways to target a particular return. If we assume that bank deposit rates are 0 per cent, the expected return from bonds is 5 per cent, and that from shares is 10 per cent; to aim for a return of 5 per cent, you can either invest the entire portfolio in bonds, or split the portfolio 50/50 between shares and bank deposits (or one of many other possible combinations).

Everyone will have a different attitude to risk and, therefore, the returns they require. By adjusting your combination of investments you can control the level of risk and affect your potential returns. This is known as asset allocation and is essential for effective portfolio management. If you or someone you now would like to know more about investing, please contact one of the Adviser fp team by (CLICKING HERE ).

Source: Lonsec Quarterly Outlook (Jan 2015); Aberdeen-Asset (Oct 2014); Adviser fp