IN THE past three years, we have seen volatility spike across equity, bond, currency and commodities markets.
A series of unprecedented events, including the Covid pandemic and the Ukraine-Russia war, led to supply chain disruptions and rising inflation.
These, in turn, pushed central banks and governments around the world to ease monetary policies while expanding fiscal spending to support economies.
The result was inflation, which started last year and led to central banks raising interest rates at the fastest pace we’ve seen in over 30 years.
All these events and actions have impacted markets globally, and caused the current volatility.
Volatility is a measure of how much an asset’s price fluctuates over time. It is a natural and inevitable feature of financial markets, and poses both challenges and opportunities for investors.
GET BT IN YOUR INBOX DAILY
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
How can investors navigate the volatile landscape of today’s markets?
The answer lies in effective risk management – identifying, measuring and mitigating the sources of risk that affect an investment decision.
Risk management is not about avoiding risk, but about balancing risk and return in a way that suits one’s risk appetite, time horizon and objectives.
Staying invested
One of the more common mistakes investors make in times of high volatility is to panic and sell their assets at a loss.
Market timing is difficult even for professional investment managers, and hard to maintain in the long run. Attempting it can lead investors to miss out on the best days of the market, which can have a significant impact on the overall performance of a portfolio in the long run.
The alternative to market timing is staying invested – being disciplined and sticking to one’s investment plan, regardless of short-term noise and emotions.
According to a study by one of the world’s largest asset managers, investors who stayed fully invested in the S&P 500 index from 1980 to 2018 achieved an average annual return of 11.8 per cent.
Those who missed just the five best days of the market each year achieved only 6 per cent. Those who missed the 10 best days each year achieved only 3.5 per cent. Those who missed the 20 best days each year actually lost 1.5 per cent per year.
Building a diversified portfolio
Another key strategy for managing risk in a volatile world is building a diversified portfolio – spreading one’s investments across asset classes, sectors, regions, styles and strategies with low or negative correlations.
Correlation measures how closely two assets move together in price. Low or negative correlation means two assets tend to move in opposite or different directions, reducing the overall volatility and risk of the portfolio.
According to modern portfolio theory, there is an optimal level of diversification that maximises the expected return for a given level of risk or minimises the risk for a given level of return.
This optimal level depends on the expected returns, volatilities, and correlations of each asset class in the portfolio. Investors can use various tools and techniques to estimate these parameters and construct their optimal portfolios accordingly.
Adding alternative investments
A third strategy for managing risk is adding investments that do not fall into the traditional categories of stocks, bonds, or cash. Examples of alternative investments include real estate, private equity, hedge funds, commodities and infrastructure.
Alternative investments can offer several benefits for risk management, such as:
- Low correlation with traditional assets: Alternative investments tend to have low or negative correlations with stocks and bonds
- Higher returns: The private market can take advantage of market opportunities and inefficiencies by sacrificing liquidity. Private credit markets can present opportunities in extending credit where banks do not operate, and private equity can present opportunities to invest in growth companies before they mature and are listed on exchanges.
- Diversification of sources of return: Different drivers and strategies include capital appreciation, income, and events
- Inflation protection: Alternative investments such as real estate and infrastructure tend to have positive relationships with inflationary pressures or expectations
Alternative investments also have drawbacks, including lower liquidity and higher complexity. Some have long lock-up periods and others take time to understand and evaluate.
Active advisory supported by data and analytics
The strategies discussed above are not exhaustive or definitive. They are meant to provide some general guidance and insights for investors who want to manage risk in a volatile world.
Each investor has their own unique circumstances, preferences, and goals that require a customised and tailored approach.
That is why it is advisable to seek professional advice from a qualified financial adviser who can help investors design and implement their optimal risk management plan.
The investment and wealth solutions team at HSBC Global Private Banking and Wealth support our financial advisers by leveraging data and analytics to enhance their advice and services.
Data analytics can provide us with deeper insights into trends and relationships, and spot anomalies. We can then make informed predictions and optimise investment recommendations.
Investing in a world of volatility requires risk management. Risk management is not a one-size-fits-all solution. It is a dynamic and ongoing process that requires constant evaluation and adaptation.
The writer is head of investments and wealth solutions, South-east Asia, global private banking & wealth at HSBC
Keyword added to your list