Minimising share market risk

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Share prices are relatively volatile compared with cash in the bank or fixed-income securities and this can be disconcerting to some investors. Volatility is caused by company-specific or economy-wide events that can make investors re-assess the long-run earnings outlook for companies, which in turn affects their share prices.

Due to the irrational passions of fear and greed, these re-assessments are also often over reactions – this can cause large share price movements in the short-term, which are then at least partly corrected later. In 2008, for example, the Australian MSCI equity index lost 40% in value, with dividend returns limiting the overall loss to 37%. This followed the three “boom” years to 2006 in which the market produced annual returns of more than 20%. In 2009, the market rebounded, returning 39% while returns in 2010 were flat.

Over the past 20 years, the standard deviation in annual returns was 18%. Assuming 8% long-run returns, and the same level of annual volatility, this implies that there is roughly two-thirds of a chance returns will be between 26% and minus 10% in any given year.