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How Much Volatility Can You Take?

11 May 2023

 

Investors have experienced worrying volatility in recent years, but you could tailor it to suit your risk appetite through diversification

In recent times investors have needed strong nerves. Take 2022: European equities reversed much of the previous year’s gains, with the MSCI Europe Index falling 11.86% (in euro).

I started investing as a student over 30 years ago, since when I been fortunate enough to benefit from the long equity bull market but have also sweated through severe bouts of market volatility. Think of the dot-com stock market crash in 2000; the global financial crisis (GFC) of 2008-2009; the Covid-19 pandemic of 2020.

Volatility is an integral part of investing. You can’t make gains over the long term without some nervous moments. It’s also a personal thing: you need to decide how much volatility you can bear, in the knowledge that the most volatile investments are generally (not always) the ones that bring the greatest gains over longer periods of time.

It helps to understand volatility. The most common way to measure it is through standard deviation. This is a statistic that measures the degree of variation of the investment’s returns compared to its average returns. The more volatile the investment, the more it deviates from the average.

From Statistics to Sleepless Nights

Looking back over the last 15 years of financial data gives a picture of the volatility of different types of investment. You can see that real estate equities have been the most volatile investments with an annualised standard deviation of 19.3% and equities as a whole have recorded 17.3%. Meanwhile, bonds normally have a far lower standard deviation. In other words, bonds would have given you far fewer sleepless night but at the cost of lower expected capital gains.

Volatility of Different Asset Classes

Annualized Volatility

Source: Bloomberg, ICE Data. Data from 31 Dec 2006 to 28 Apr 2023 in USD, Net Return. Global Equities are represented by the MSCI World index, Listed Real Estate by GPR 250 Index, Global Corporate Bonds by ICE BofA Global Corporate Bond Index, Global Government Bonds by ICE BofA Global Government Bond Index.

You can also look at the chart below to see how these different types of investment have reacted to the market shocks of the past 15 years, from the GFC in 2008 to the pandemic in 2020.

1 Year Rolling Volatility

Source: Bloomberg, ICE Data. Returns used from 31 Dec 2006 to 28 Apr 2023 in USD, Net Return. Global Equities are represented by the MSCI World index, Listed Real Estate by GPR 250 Index, Global Corporate Bonds by ICE BofA Global Corporate Bond Index, Global Government Bonds by ICE BofA Global Government Bond Index.

Interestingly, volatility characteristics are fairly persistent. So if a type of investment has performed with a certain level of volatility in the past, it’s likely to continue to do so in the future.

Matching Volatility to Your Nerves

You could tailor volatility to your own appetite for risk. One way of finessing this is to mix different asset classes, dialling up or down the levels of volatility through diversification across different types of investment. Often known as the only free lunch in investing, diversification lies at the heart of how big institutional investors adjust levels of volatility to their own risk appetites. It works because different types of asset generally have low correlations to each other, meaning they mainly don’t all fall at the same time. As with anything, though, there are exceptions to this rule, such as in 2022’s fall in financial markets, when equities and bonds declined together.

Our multi-asset ETFs illustrate how you can use diversification – in this case through differing blends of equities, real estate equities and bonds – and how it has tended to work over long periods, even if this cannot be guaranteed for the future. Going back over the 14 years since the launch of these funds in 2009, the chart below shows how the volatility – of standard deviation – of their prices varies from one to the next. However, it’s also worth noting that the most volatile also has the highest returns. Conservative has an annualised return of 2.9%, Balanced 4.0% and Growth 5.1%.1

Volatility of the Multi-Asset ETFs

Source: VanEck. Data from 14 Dec 2009 to 30 Apr 2023 in EUR, Gross Return.

Ultimately, normally the appetite for risk-balance comes with the appetite for returns. Young people, who normally have a long-term investment horizon, usually have the risk capacity to weather more volatility and ride out the crises in the quest for longer-term gains. Older people, who might need to cash in their investments relatively soon, probably want to start trimming back risk.

Speaking personally, I am about to turn 52, have seven children and two grandchildren. I invest across our range of VanEck ETFs, but have less nerve than I did as a 20-year old student with no ties.

1 Source: VanEck, Gross Return in EUR. Data from 14 Dec 2009 to 30 Apr 2023.

Important Disclosure

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