Three charts advisers use to explain volatility to clients

Volatility and investment risk can be tough concepts to explain to clients. Graphs can be used to great effect, as this trio of advisers will testify...

An all-time favourite

For Roddy Kohn, managing director of Bristol-based Kohn Cougar, helping clients to get to grips with “much misunderstood investment fundamentals” entails trotting out his ‘LPC’ – “little spiritual chart”.

His “all-time favourite chart”, it depicts returns from a range of UK asset classes over the long term, with and without dividends reinvested, alongside notable points in financial history.

“I’ve often sat next to a client silently letting them ponder the enormous amount of data squeezed on to one side of A4 and progressively seen the consternation on their brow fade like the wisp of a cloud,” says Roddy.

“The whole process reminds me of the remarkable Horrible Histories books given its references to the tumultuous decades of stock market fatigue, blood on the streets and other tales of gore and woe.

“Many an investor has been exposed to such woes undeniably, but for those who had held their nerve then this chart reveals that fortune, indeed, has favoured the brave.”

The chart helps to counter the short-termism that can befall even experienced investors, according to Roddy.

“It does no harm to roll it out on a yearly basis as part of the annual review to simply express: ‘This is what investing is all about.’”

The risk-return relationship

Dundee-based Verus Wealth uses images (rather than data) wherever possible in client presentations.

Co-director Paul Lothian, a chartered and certified financial planner, says: “Diagrams and graphs are more readily understood than tables of data. Colourful charts graphically tell the story.” The adviser spends a “good deal of time” educating clients in investment matters and ensuring that they grasp the fundamentals of capital investing.

“One of the basic building blocks of this is the relationship between risk and return, which we must explain carefully to ensure clients understand and accept that if they want higher returns they must take more risk,” says Paul. “There is no such thing as an ‘investment free lunch’!”

Verus Wealth’s equity portfolios include an allocation to global small/value stocks due to the risk premium derived from this. “This additional risk is rewarded over time,” says Paul.

His favourite chart demonstrates the overall returns for cash, gilts, global equities and global small/value and visually illustrates the associated volatility.

“Having explained that risk and return are related, this graph proves the point in a visual way that clients can quickly assimilate. In practice, we use a dynamic tool, so we can represent the data over various time periods and introduce different asset classes.”

The impact on returns

Understanding when to embrace volatility and when to be watchful can be counter-intuitive, according to Andrew Chorley, managing director of Financial Planning Wales.

“Low levels of volatility can suggest investor complacency whilst high levels can indicate investor concern and are often accompanied by market declines,” says the chartered wealth manager. “The VFTSE [FTSE 100 volatility index] was very low prior to the financial crisis and very high during 2008/9 – the exact time volatility should have been embraced.”

The Cardiff-based firm has developed its own framework to help gauge risk. Using the FTSE 100 due to the availability of data, it takes measures such as the distance of the index from moving averages, multi-year highs/lows, trend, volatility and correlation to other indices and puts them into a percentile rank – creating a simple average plotted over different timeframes.

The resultant chart, one of a number it uses, depicts periods of low and high volatility and subsequent returns over the next five years. In 1998, risk was at an all-time high of 93% and volatility very low; the FTSE 100 lost 9.6% per annum over five years. In 2009, volatility was high but risk levels at an all-time low of 1.74%; subsequent returns were 13.7% per annum.