To understand which investment types can help manage risk, we need first to define risk. This might seem like a redundant thing to do since most people have some idea of what risk is. The problem is that risk can mean different things to different people.
What is Volatility Risk?
For this discussion, risk is volatility that can result in capital loss. Formalizing the definition of risk puts everyone on the same page. Because we are focused on the loss of capital, we are more interested in downward moves in price rather than upward. Let’s dig a little deeper into this definition.
Volatility is the fluctuation in the price of an investment. This is also close to the definition of risk as outlined by the Nobel Laureate Howard Markowitz (i.e., standard deviation) in Modern Portfolio Theory.
Why are fluctuations in price considered a risk? If the price shoots up from our cost basis, isn’t that a great (unrealized) return? The problem with price fluctuations is that you don’t know which way the price will fluctuate and how much.
The degree to which price fluctuates can be a more detailed measure of risk vs. just price movements in general. Small price fluctuations may not present as much risk as large fluctuations. Going back to capital loss, a small downward price move will result in a smaller capital loss than a large downward price move. Additionally, when viewing risk, we are really interested in downward price moves since they have the opportunity to go below our cost basis.
For example, we buy 100 shares of stock at $100, which is now our cost basis. If the price moves to $95, we may not be as concerned vs. a move to $60. The larger degree of movement results in a larger (unrealized) loss of capital. Or, said another way, it presents a larger risk. This is lower volatility vs. higher volatility.
From the above discussion of risk, we can see that the least volatile investments are those that have small price movements. Cash might be considered to have the smallest price movements (as it relates to inflation). Although it is an asset class, it isn’t an investment. While the latter point can certainly be debated, we consider an investment as one that you put cash into. Cash that is sitting on the sidelines isn’t invested. Below are a few low volatility investments.
Bonds tend to be less volatile than stocks because their coupon payments are typically known and consistent. Comparatively, a stock’s future price is unknown. The risk with bonds is default and reinvestment risk: The possibility that an investor will be unable to reinvest cash flows (e.g., coupon payments) at a rate comparable to their current rate of return. However, if you are investing in Treasuries, that risk is non-existent. In fact, Treasuries are the benchmark for the risk-free rate.
Low Beta Stocks
Low beta stocks and ETFs (exchange traded funds) have lower volatility than their benchmarks but higher volatility than bonds. A low beta stock or ETF is one that has a beta that is much lower than its benchmark. For example, American Tower Corporation (AMT) has a beta of 0.25, and GlaxoSmithKline (GSK) has a beta of 0.32. Their betas are based on the S&P 500. A beta of 1.0 means the stock has the same volatility as the S&P 500. The low betas mean that both stocks have lower volatility than the S&P 500.
Low beta ETFs work in the same way. Specific investments make up the concentration of a low beta ETF, which is designed to reduce its volatility compared to a benchmark.
Real estate can be considered to have low volatility. The primary reason that real estate has low volatility is because of illiquidity. When an investment is illiquid, price discovery is difficult. Without real-time price discovery, volatility is suppressed.
Illiquidity presents its own risk. If you need to sell an illiquid investment fast, you may have to take a significant price cut to find the current market price.
Risk is a complex topic. We’ve only touched on it at a high level in this article. When starting a discussion about risk, it’s important to define what you mean by risk specifically. Then you can speak to risk more accurately within the context of that definition.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
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