Risk and expected returns: The inevitable trade off and how to improve it to the advantage of the SA economy.
Equities are more risky than fixed interest (bonds) and bonds are more risky than cash. Hence equities must be expected to return more than bonds and cash, as compensation for investors willing to bear the extra risk associated with shares. The risk we bear when owning different assets is that we cannot be sure what they will be worth in the future when we might be forced to cash in – the next day, month, year or even, in the case of active traders, in twenty minutes’ time. Hence the more risk, the lower will be the prices attached to assets so that expected returns improve.
Past performance of SA assets provides very strong support for the theory that more risk is accompanied by higher returns. Shares in general have returned significantly more than bonds or cash (in the form of capital gains and dividends or interest received over successive 12 month periods) for SA wealth owners since 2000. But these higher returns have come with significantly more risk, as measured by the movements around the average 12 month returns, calculated monthly. The JSE All Share Index returned an average 16.12% over this period, with a Standard Deviation (SD) about this average of 17.8% p.a. In the worst month for shareholders over this period, February 2009, the 12 month returns on the JSE were a negative 43% while in April 2006 shareholders were up 54% on a year before. The bond market returned an average 11.3% over the same period, with a much lower SD of 6.7% and a worst month, April 2014, when the All Bond Index (ALBI) returned a negative 3.1% over the previous 12 months. The best month for the ALBI was the 27% annual return realized in June 2001. Cash on average returned approximately 8.2% p.a between January 2000 and 2015 with a SD of 2% p.a.
Since inflation averaged 5.9% p.a over the period, all asset classes have provided very good real returns, higher on average than could have realistically been expected back then and more than could be expected over the next 10 years. Such excellent returns, if they are to be repeated, would have to be accompanied by excellent management of the capital invested by SA listed companies and a lower SA risk premium demanded by foreign investors. It was this potent mixture of good management and less risk priced into the JSE share and bond markets that delivered such excellent past performance.
The more the cash in value of any asset varies from day to day, the more uncertainty about their cash in value and so the more risky this asset. In the figure below we show the daily percentage move in the JSE All Share Index and the S&P 500 Index. The price of any individual share included in this index is likely to be more variable in both directions than that of the average share represented by the Index.
This day to day volatility can be measured as a rolling 30 day average SD of these price moves. It will also be reflected in the cost of an option on the Index. The more volatile the market is expected to become, the more expensive it will be for investors to insure against such volatility by buying or selling an option to buy or sell the Index at an agreed, predetermined value. The cost of such an option on the S&P 500 is indicated by the Volatility Index (the VIX) traded in Chicago sometimes described as the fear index. The higher the value of the VIX, higher the cost of an option on the market and the more the fear. The VIX may be regarded as a forward looking measure of expected volatility and the rolling SD as a record of past volatility. Yet past volatility appears to strongly influence expected volatility as we show in the figures below. We also include in the figure the rolling SD of the euro/US dollar exchange rate. It should be noted that volatility appears to revert back to some long term average of about 12. It spiked up dramatically during the global financial crisis in 2008. It also spiked during the various phases of the European debt crisis of 2010 and 2011. Volatility in the share markets now appears as close to average. The VIX had a value of about 14 yesterday. See the figure below.
We provide a close up of recent daily volatility in a further figure below. Volatility moved higher in late 2014 and early 2015. In the share market, volatility has moved back to the long run average very recently while volatility in the key foreign exchange market, the euro/US dollar rate, volatility has moved in the opposite, higher direction.
The relationship between volatility or risk of holding a share and its price, that is the return realised for the owner, is almost perfectly negatively correlated. So if volatility rises, share prices will move in the opposite direction in a highly predictable way. The figures below for the S&P 500 illustrate this. The correlation between daily percentage changes in the VIX and the S&P 500 is a negative 0.84 for daily closing prices since January 2014. The negative relationship between the recent decline in volatility on the value of the S&P 500 Index (volatility up, share prices down), is also illustrated.
Correlation does not however mean causation. The cause of share price or exchange rate volatility is in the degrees of uncertainty felt by investors about what the future may hold for the economy and for the companies and currency traders that are influenced by by these economic developments. If the world could be predicted with certainty, there would be no reason for prices to change; no reason for investors to change their mind about future prospects and so to force prices lower or higher to reflect their less or more optimism about future prospects. For every buyer who must think prices will rise in the future to provide attractive returns, a profit seeker willing to bid up an asset price, there will be a seller (a profit taker) who thinks the prices or the market in general will move in the opposite direction. The more uncertain the future appears, the more they will tend to disagree and the more prices will move widely in both directions from day to day to reflect their differences of opinion until something like greater calm in the markets resumes. This degree of movement in both directions, up then down, down then up, is what makes for volatility. The random price walk that always characterises asset price movements over time s can become abecome a wider or narrower path as prices fluctuate one with wider or lesser changes in both directions over time, as has been illustrated above.
ByG greater calm in the market place is characterized by smaller swings in prices from day to day or even within a trading day resulting in smaller moves, implies one associates with a higher degree of consensus about the state of the world and so the less reason incentive for market participants to push prices more sharply in one and the other direction, when markets are highly liquid and attract many buyers and sellersMore volatile markets, that is wider price swings in both directions, imply a higher degree of dissonance about future prospects.. Changes in market prices Volatility reflects essential disagreement between market participants about the state of the world and the prospects for companies. And prices fall as volatility rises in order to provide investors in general with higher expected returns to compensate for these greater perceived risks.
Thus it might help market participants trying to time correctly their entry into or exit from the market to ask a different question – not where the market is going, but rather where will volatility be going, that is will the world become more or less risky? That is because if it does become more or less risky as prices fluctuate over a wider range, the value of relatively risky assets (perhaps all assets other than the true safe havens – perhaps only US Treasury Bills and Bonds) will move in the opposite direction. Or in other words, the question to ask is not what is the likely outlook for the economy etc. but rather, what is the outlook for the economy and for listed companies, currencies and almost all bonds?
Another way of putting it is to ask whether market views will have reason to become more or less diverse. Will events evolve that become more or less easy for market participants to interpret? Will it become easier to solve the known unknowns that investors recognise as consistently driving valuations? A global financial crisis is a very unusual event, the outcomes from which were extremely difficult to agree about – hence the volatility in 2008 and 2009. A Eurozone debt crisis raises uncertainty about how it will all work out for share prices interest rand exchange rates – as would any breakup of the Eurozone system, another first time possibility for which history supplies little guidance..
Hence the obligation for policy makers to act as predictably as possible. Certainty in economic policy reduces risks for investors and helps raise values. Less risk means higher asset prices and lower expected returns. If SA wishes to attract foreign and domestic capital on superior terms, the aim should be to reduce the high risk premium attached to incomes dependent on the SA economy. High returns of the kind earned by investors in SA assets since 2000 might well be realized, should the SA risk premium come down rather than go up over the next few years. The SA government could do a much better job than it has been doing to introduce certainty in its economic policies and, as important, certainty that the right income enhancing policies are being adopted.