Coping with risk when market volatility is high

 

The performances of bonds and fixed-income securities between the end of May and the beginning of June are proven testimonials to the above statement.

In May, just because of whispers from the US Federal Reserve that it likely would be appropriate to increase the target range for the federal funds rate in June, global bonds, normally considered a safe asset, went wild.

The price of 10-year US Treasuries dropped by 2 per cent right after the Fed’s statement was released. In the meantime, yield of Thai government bonds rose from 1.77 per cent to the highest yield-to-maturity rate of 2.34 per cent, equivalent to an almost 5-per-cent loss in value in less than two weeks. The market was shocked by the Fed’s early signal on an interest-rate increase.

But wait – what would you say if I told you that those pains, the worst year-to-date, reversed completely just a week later?

Were we surprised? Of course! 

In fact, the fear of a US rate increase in June completely disappeared, just because of the poor state of the job market in the United States.

From my point of view, the market is not over-dramatised, but we are in a period of highly volatile markets. Needless to say, my example is just the case of bonds. 

If we also invest in equities or commodities, we surely have to face even more volatility.

People know that the current investment world is quite a cruel place, but we still have to take some risk if we want to build our fortunes. 

Can we ignore the short-term risk and focus only on the long term? Or is the market always a risky place and we just need to accept it?

To answer these two critical questions, I can share the observation of 25 years of the performances and risk characteristics of five asset classes in Thailand. 

As proxies, “commodities” are represented by gold, while “stocks” are represented by the SET Index. “Bonds” are measured by the total returns index of government bonds from the Thai Bond Market Association. “Property” return is estimated by the Bank of Thailand’s housing index. 

And last but not least, the average commercial-bank savings rate is “super-safe cash”.

My model is quite simple.

The rule on making an investment decision is to search for the portfolio, a combination of the five asset classes, that provides the highest yield per unit of risk, where investment profit is measured by the portfolio’s total yield and the risk is estimated by the variance of the portfolio.

Believe it or not, history shows us that if we do not have any required rate of return, the best portfolio structure should be 5 per cent in property, 1 per cent in equity, and 3 per cent in bonds, while the remaining 91 per cent should remain in a deposit account.

In other words, the risks in capital markets are always high.

Investors are rational to ask for low-risk assets or a higher investment rate in Thailand, since the rewards for holding other assets are too thin compared with the risks. 

However, we also know that we cannot ask markets to behave rationally just because of our fear of losses. We have to set some investment goal, take some risks, and invest as if there is no free lunch. 

Based on my risk-return asset-allocation perspective, money should move out of a deposit account only if we expect to reach an investment goal of more than 2 per cent per year. 

In Thailand, the ranking from the best to the worst investment in terms of return per unit of risk is bonds, property, gold, and equities.

The Thai bond market is a very good starting point for every investor who requires no more than a 5-per-cent annual rate of return, while property investment should be a place for diversification. 

Last, equities and gold are needed only if we want to expand our return-on-investment target beyond 7 per cent per year.

That is what I can tell you about the asset-allocation choice in Thailand.

Mark Zuckerberg once said: “The biggest risk is not taking any risk ... In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks.” Likewise, volatility is not to be loved but to be understood and dealt with properly.

Although he might be right, immense volatility in the capital market is still frightening. Yet failure to understand this challenge could damage wealth-creation potential in the long run.

Let us hope we can consider the pros and cons properly.

 

Views expressed in this article are those of the author and not necessarily of TMB Bank or its executives. 

Jitipol Puksamatanan is a global economist and currency strategist at TMB Analytics. He can be reached at [email protected]