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Is volatility risk?
November 2014

After a long period without significant market upheavals, Scott Lothian

Global Strategic Solutions
investors might be forgiven for pushing volatility down their
list of concerns. We think that would be a mistake. Low
volatility can sometimes represent the calm before the storm.
But even when the storm hits, we don’t think volatility is
necessarily something to be feared. It can indicate danger,
but it can also signal opportunity. What is crucial is that
investors are able to determine which and have a plan ready
so they can react appropriately.
Growth of £100
How investors approach volatility depends critically on
120
the immediacy of their targets. Short-term investors may 115
find that volatility management techniques are useful. 110
However, for those focused on the longer term, volatile 105
100
markets can present significant opportunities to enhance 95
results. In this article, we try to quantify the short and long 90
85
term and look at ways investors can overcome their natural 80
aversion to investing in volatile markets. 1 2 3 4
Asset A Asset B

Defining our terms For illustration only. Source: Schroders, as at October 2014.
Modern portfolio theory defines risk as volatility and
tells us that there is a proportional relationship between There are, of course, many other ways of defining
volatility and expected returns – an investor must accept investment risk. For many investors it is simply the
uncertainty if they are to generate returns in excess of the possibility of permanent loss, but for some it is more
‘risk-free rate’. Thus it is most efficient to minimise volatility specific. For example, a pension fund might consider its
for a given level of return, or maximise returns for a given main risk to be having insufficient assets to meet the
level of volatility. retirement needs of its pensioners. For a sovereign wealth
fund, the most worrying issue might be owning a stake
Under this definition, volatility is a measure of the variation in a company involved in some illegal activity. Insurance
in results, typically expressed as their standard deviation companies, on the other hand, might consider the major
from an average level. This can, however, lead investors risk to be illiquidity, i.e. not being able to sell assets when
astray. Take the simple example of two assets, A and B, in needed to pay claims. For most investors, an ever-present
Figure 1. The statistical volatility of A is far higher than that concern is whether the purchasing power of their money
of B; indeed, technically, B has zero volatility. However, it is will be eroded by inflation.
obvious that, over the three-month reference period, asset
A was the better investment to own. It is clear that the terms ‘volatility’ and ‘risk’ are not
synonymous. Yet, although they are used more or less
interchangeably, very few people would be satisfied if
Figure 1: Lower volatility does not necessarily mean
the answer they received to the question ‘what’s the risk
better returns
of this investment?’ was simply ‘five’.
Month Asset A Return Asset B Return
Sequencing risk
1 8.0% -5.0%
Much analysis of risk assumes that an investment is
2 4.0% -5.0% affected in the same way whenever returns occur.
In truth, of course, timing is vital. A 10% market fall
3 -4.0% -5.0% when a saver is 25 and their accumulated savings are
small should be much less traumatic than when they are
Compound Return 7.8% -14.3%
45 and their savings are likely to have grown to something

1
Figure 2: Timing + Magnitude = Impact
Accumulation (£’000s)
1,200

1,000

800

600

400

200

0
1973 1978 1988 1993 1998 2003 2008 2013
Actual Experience Weak 1980s, Strong 2000s

Annual data from 1974 to 2013. Assumptions: 60:40 portfolio, fees of 0.5% p.a, and 10% contributions made mid-year.
Source: Barclays Equity Gilt Study 2013, ONS UK Average Salary data and Schroders, as at 31 December 2013.

more substantial. The order in which returns takes place a blunt instrument at best as it can only give some control
can make a significant difference to the final outcome. over the magnitude of possible losses, and none over their
This is sometimes termed ‘sequencing risk’ – the impact of incidence or timing.
the pattern of returns on money-weighted results.
An alternative way to control sequencing risk is through
Crucially, higher volatility increases the exposure to active management of the portfolio to try and avoid steep
sequencing risk. Figure 2 shows the sensitivity of a pension falls in value. This leads to outcome-oriented strategies,
saver to this risk. The blue line represents the hypothetical such as low-volatility hedge funds, flexible fixed income or
savings of someone who started a defined contribution multi-asset portfolios. In practice, a blend of these solutions
(DC) pension in January 1974 and retired 40 years later. is perhaps useful. Having available a range of outcome-
(We have assumed that they had average UK earnings, of oriented strategies with varying targets and volatility
which they saved 10% annually, and maintained a 60:40 tolerances will help in striking the right balance between
allocation between equities and bonds.) By the time they achieving real returns and avoiding major crashes.
retired they had savings of almost £500,000.
Spotting the difference between threat and
The orange line shows what might have happened had opportunity
they instead experienced a bull market in equities and
Are there time horizons over which volatility does
bonds in the last few years leading up to retirement.
constitute a significant risk? The answer depends very
We created this alternative scenario simply by switching
much on the relationship between volatility and returns.
the relatively poor returns of the 2000s with the relatively
Statistically and empirically, high market volatility is
strong returns of the 1980s. The switch has no impact
associated with negative returns. But if returns have
on compound annual total returns over 40 years measured
recently been negative, then the market will now be
on a time-weighted basis. However, it does have a major
priced more cheaply than before, which should provide
impact on the final value, because the strong returns in
a buying opportunity.
the final decade acted on a much larger sum of money.
In this scenario the final sum is over £1,000,000 – more Of course, the potential for higher expected returns
than double that of the ‘actual’ DC saver. This exercise comes at the cost of a greater probability of significant
highlights the heavy toll on our saver’s pension pot loss. This is a trade-off the extent of which varies with the
caused by the flat-to-falling returns of the 1990s and the time period being considered and the objectives of each
crash of 2007–2008, both of which happened late in their investor. Figure 3 shows the weekly returns from the S&P
savings journey. 500 Index over the past 54 years (blue line) and the subset
when the preceding volatility was relatively high (orange
In short, therefore, the final value of DC pension savings
line). The distribution of returns in the high-volatility subset
is very dependent on the path taken. An early setback will
shows significantly more extreme results (‘fatter tails’)
have limited impact on the end result, whereas a market
than the full sample, while the median is more or less
crash close to retirement can mean serious impairment.
the same for both sets of data. Figure 4 shows the return
Since, intuitively, lower volatility leads to a tighter range distributions for annual periods for the same index over
of expected outcomes, managing portfolio volatility is the same history.
one way to attempt to try and manage sequencing risk.
This time the high-volatility subset tails are slightly fatter,
However, there is a cost to this approach in terms of lower
but the median return is significantly higher.
expected returns, and at times this ‘insurance premium’ is
too expensive. Moreover, simple volatility management is

2
Figure 3: After a volatile period, we see more extreme results
Frequency (%)
10

8 Median:
All periods 0.26%
Similiar Expected Returns High-vol subset 0.30%
6

4
Higher Chance of
More Extreme Results
2

0
–20 –16 –12 –8 –4 0 4 8 12 16 20
High-volatility Subset All Weekly Periods

Daily data from 31 December 1959 to 30 June 2014. Index used is the S&P 500 Price Return. One-month volatility look-back. High-volatility subset refers to top decile historical
volatilities. Source: Bloomberg and Schroders.

Figure 4: Annual results still have downside exposures but stronger value premiums
Frequency (%)
6 Median:
All periods 9.63%
Higher Expected Returns High-vol subset 16.43%
5

4
Some Threats Remain
3

0
–60 –48 –36 –24 –12 0 12 24 36 48 60
Return %
High-volatility Subset All Annual Periods

Daily data from 31 December 1959 to 30 June 2014. Index used is the S&P 500 Price Return. One-month volatility look-back. High-volatility subset refers to top decile historical
volatilities. Source: Bloomberg and Schroders.

Figure 5: When does volatility matter?

Return (%)
40
High-volatility
Subset
30
Upper
Risks generally outweigh returns/benefits Decile
20 Median
Lower
10 Decile

0
All Data
–10 Upper
Decile
–20 Median
Added return per risk potentially more attractive Lower
–30 Decile
Daily Weekly Monthly 3 Months 6 Months 12 Months 18 Months 24 Months 36 Months

Return Periods Examined

Daily data from 31 December 1959 to 30 June 2014. Index used is the S&P 500 Price Return. Results over 12 months are annualised. One-month volatility look-back. High volatility
subset refers to top decile historical volatilities. Source: Bloomberg and Schroders.

3
In the short term (Figure 3), the frequency of weak We further analysed many different periods, volatility
returns following high volatility usually offsets any subsets and investment horizons to draw broad
benefits to be gained, so market volatility represents conclusions, based on a typical investor’s likely goals.
a threat. For those investors likely to be sensitive to We concluded that high market volatility posed the
such losses, the use of portfolio volatility management greatest threat for those with a horizon below three
techniques, such as volatility capping or targeting, months and offered decent opportunities for those
can therefore be an attractive option. with horizons from six to 24 months, while the distinction
tended to fade beyond 24 months. Figure 5 summarises
However, the very same signal – a period of high market the analysis, showing the dispersion of results for
volatility – can also trigger the completely opposite differing investment horizons.
response. Investors willing to withstand a short stormy
period can take advantage of others’ near-term concerns to
exploit cheap valuations (Figure 4). This is a manifestation
of the value effect, whereby those targeting longer-term
investment outcomes can profit from volatility.

Conclusion
Our conclusion has to be that volatility is not risk. Rather, it is one measure of one type of risk. Pragmatic
investors recognise this, and appreciate that its use as a proxy is an imperfect short cut. Volatile markets certainly
bring uncertainty about whether investors’ goals will be achieved. At the same time, volatility is also a very
useful indicator, a warning of both short-term threats and longer-term opportunities. For those concerned about
the near term, volatility management techniques may be useful tools for increasing certainty. But for those
more focused on longer-term outcomes and able to weather the storm, volatile markets can present significant
opportunities. Armed with these insights, investors should be able to take better allocation decisions at times of
market stress.

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