Portfolio volatility is damaging to your unit trust investment

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BASED on my observation, many unit trust investors bought mainly equity-based funds, meaning funds that invest mainly in stock market. These funds are volatile, meaning the value of the units can go up or come down substantially, some times as much as 50 per cent in a financial crisis, such as the aftermath of 2008.

Many investors are unaware of this fact. If your portfolio falls 50 per cent and then increases 50 per cent you are not even! You have actually lost 25 per cent of your portfolio. If you have RM1000 and lose RM500, now you only have RM500 in principal left; so the 50 per cent increase on the RM500 left, not the RM1000 you originally had.

By the way, the same result occurs if the sequence is reversed. If you make 50 per cent and then lose 50 per cent you have still lost 25 per cent of your portfolio.
Examples of Portfolio Volatility

Now take a look at this example of 3 portfolios over a period of 6 years. All three portfolios have an average return of 5 per cent over the 6 year period.

Portfolio B experiences 10 per cent more volatility each year than portfolio A; both in the up and down years. Portfolio C experiences 25 per cent more volatility than Portfolio A.

Did you notice that the greater the portfolio volatility the lower the return on the portfolio?

As you can see, the average return is the same (5 per cent) for all the portfolios.  Yet because of compounding the ending values of the portfolio are quite different.

When you lose your investment capital you no longer have the ability to make it up when returns are positive. In other words, the positive returns are made on less money; therefore you are literally losing your money with each cycle of volatility.

Therefore volatility has a large negative effect on portfolio performance.
Diversification

Proper diversification puts a distinction between investing and gambling. If you are taking risk that could have been reduced by diversification, then you are taking unnecessary risks for which you are not being compensated. Remember investing is not gambling.

By combining different assets whose returns are not perfectly positively correlated, or are even negatively correlated, the volatility of the combined assets (called a portfolio) is reduced.

This is a simple way to understand the Nobel prize-winning theory, called Modern Portfolio Theory, a theory in finance and investment, which explains why diversification can reduce the total variance (volatility) of the portfolio return.

Let me put it in a simple language. When you combine assets, which have prices that do not move up or down perfectly together, or even better, the prices do not even move together, the price ups and downs (called volatility) of the combined assets (portfolio) actually reduce. In investment language, we say the portfolio volatility is reduced.
Suggestion

Therefore, when you have already hold many unit trust funds that are exposed to stock market, it is wise to add in funds that are not affected by the stock market ups and downs. But very few of these types of funds are in the Malaysian market now.

Two examples that you should look at are absolute return funds and private equity funds.

The prices of these funds usually do not correlate with the stock market, and are ideal to add into the mix of your unit trust portfolio to reduce your overall unit trust portfolio volatility.
For further enquiry, contact Lee Khee Chuan ChFC,CFP,CLU,FLMI,B.A.(S’pore), a Bank Negara & Securities Commission-licensed financial adviser representative and director, advisory and practice management of Standard Financial Adviser Sdn Bhd at 016-8880138.