Avoiding the effects of volatility

Avoiding volatility - private market investments

by Edward Robertson and Peter Falohun
[revised 18 November 2016]

In Modern Portfolio Theory, volatility, measured as standard deviation, has become "the most used gauge for investment risk". [1] 

Volatility is a measure of the variability of a security's price, or of its returns. The basic meaning is fluctuation or deviation from the mean; it is used as a proxy for risk, giving a kind of shorthand to characterize a security.

Let us focus on volatility in the sense of downturns in the price or reduced distributions of an asset, in the short to medium term (even if the asset later recovers). We identify underlying causes and downstream effects, stated as risks, and consider mitigation using private assets investments.

Internal and external causes of downturns
The causes of downside volatility fall into two broad classifications.

First, the asset may lose value or fail to pay distributions due to failing fundamentals, a poorly conceived business model, or poor management – let us call them internal causes. Second, uncontrollable market demand forces that are unrelated to the business fundamentals can drive the price down – let us call these external causes.

Risks incurred through volatility
At least three specific risks are incurred due to the internal and external causes:

Risk #1. FORCED SALE AT A LOSS. A depressed trend coupled with an inflexible exit date (e.g., need for emergency funds or retirement) forces the investor to sell at a loss.

Risk #2. STRESS-INDUCED SALE AT A LOSS. The emotional stress experienced at downturns, and during oscillations, gives stress to the investor, and induces one to sell prematurely at a loss.

Risk #3. LOST OPPORTUNITY IMPOSING DRAG ON RETURNS. Downturns impose an opportunity cost to the investor, leading, especially in the absence of a dollar-cost averaging strategy, to unmitigated notional losses (drag on returns).

Do private assets incur these risks?
Let us take private investments roughly similar to publicly traded securities that would have incurred the risks above. Are the private assets susceptible to the same risks?

1. PARTIAL MITIGATION. In the midst of a general downturn that drives publicly traded stocks down (regardless of fundamentals), private assets can preserve their valuations and maintain their distributions.

At the same time, private investments will likely have penalties and reduced options for liquidity. Therefore private assets would only partially mitigate the risk of being forced to sell at a loss because of inability to time the market.

2. MITIGATION. Private assets, to the extent they are shielded from the ups and downs in the public exchange, cause correspondingly less emotional stress, signifying less likelihood to sell merely through fear of further loss.

3. MITIGATION. Private investments, if generally sheltered as described, and if otherwise sound, have greater ability than do publicly traded securities to avoid opportunity cost. Instead of letting external forces destroy their valuations, they perform according to the original design of the business activity. They can continue to remain solvent, pay distributions and build capital during downturns.

Private assets are, of course, not immune to internal risk; i.e., faulty fundamentals, operations problems or bad management. Also, the structure of the investment products either makes them illiquid, or imposes a penalty for early redemption. However, private investments are removed from the direct effects of news events, public sentiment, stock market manipulations, and the action of foreign markets. We conclude that private market investments can help to mitigate the more serious volatility risks incurred through external adverse forces.

[1] Investopedia, "Modern Portfolio Theory and Risk"

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