Most of us understand volatility as something that is negative for stock markets. Volatility is the extent to which the stock price or stock returns deviates from the mean or the arithmetic average. Normally, higher the variance, higher is the volatility. Volatility is important because it reflects the risk in the stock. Normally, risky stocks tend to be more volatile. For example, a stock like Yes Bank can fluctuate by up to 40% in a single day. It is hard to find that kind of volatility in a stock like HDFC Bank or even in HDFC or even in a Kotak Bank. Higher volatility is associated with higher risk and therefore they are also associated with lower risk adjusted returns for the investor. That is why volatility matters so much for your portfolio.
How volatility impacts the portfolio returns?
To understand the concept of volatility let us delve a little further into a real life example of 3 portfolios. The 3 portfolios; Alpha, Beta and Theta have the same arithmetic mean of returns over a 6 year period. Does it mean that their returns will be the same? Not exactly if you look at the illustration below. What exactly does this illustration demonstrate?
|Year||Portfolio Alpha||Alpha Value (Start Rs.1 cr)||Portfolio Beta||Beta Value (Start Rs.1 cr)||Portfolio Theta||Theta Value (Start Rs.1 cr)|
The three portfolios above are giving the same average mean returns but the portfolio values are vastly different at the end of 6 years. Why does this happen? The answer lies in volatility. You will see that as the volatility consistently goes up from Alpha to Beta and from Beta to Theta, the eventual portfolio value is coming down. Portfolio Beta is more volatile than Portfolio Alpha and Portfolio Theta has the highest degree of volatility. The portfolio returns are inversely proportional to the extent of volatility in the portfolio returns. In the above illustration, Rs.1 crore invested in Alpha grows to Rs.1.34 crore in 6 years but just grows to Rs.1.30 crore and Rs.1.12 crore in case of Beta and Theta. Clearly, the higher volatility is playing against the latter two portfolios. But what is that so? There are 3 reasons:
- Power of compounding works in favour of consistency
This is a fairly straight forward point. The power of compounding works best when the mathematics is in your favour. If your portfolio grows at 10% annualized for 2 years then Rs.100 becomes Rs.121. On the other hand, if your portfolio gives -20% returns in the first year and +40% returns in the second year you are still going to be at Rs.112 at the end of 2 years. In this case, the mean returns are 10% over two years. But due to the power of compounding, the higher volatility works against wealth creation. A little bit of volatility is like inflation. Just as inflation is essential for any economy, volatility is essential for any portfolio. It is when volatility becomes erratic that you have a problem.
- Human mind reacts negatively to high volatility
This is a psychological aspect and normally leads to decisions in haste. Let us look at a scenario where the portfolio falls sharply by 20% in the first year. Most fund managers may have a risk limit up to which they can hold stocks and hence be forced to stop out the positions. Secondly, when a portfolio is down by 20%, there may be a rush for the exits as investors start panicking. This will force the fund manager to sell stocks in a hurry, at times even at losses to make good the liquidity shortfall. This again forces negative returns on portfolios with high volatility.
- Greed on good returns leads to sub optimal decisions
Greed on good returns is another key factor. For example, if your portfolio appreciates consistently year on year, then you do not have much to worry about. Say your portfolio is up by 25% in the first year itself. What do you do? Either, the fund manager may choose to book out and lose out on future opportunities, or investors may rush for the exits. Lack of consistency in returns, even on the upside can actually lead to sub optimal decisions.
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