In 2017, the U.S stock market had one of its least volatile periods. That soon changed drastically; the average year over year change in the Cboe VIX index, measuring market volatility, was an increase of 50% in 2018 as opposed to a decrease of 30% in the preceding year.
One could observe the same degree of volatility in the S&P 500 index, which both had an average daily return rate of 0.74% during its trading sessions in 2018, as opposed to 0.30% in 2017, and an average daily return of -0.81% on all of its down days, as opposed to -0.27% in 2017.
Fixed income market was not an exception; few to none of the economists and analysts came close to accurately predicting one of the most stable metrics present in the financial markets: interest rates for U.S Treasury. In addition to the unforeseen shifts in the interest rates for U.S Treasury, possibly even fewer people anticipated their colossal impact on global financial markets at large.
It is difficult to pinpoint the source of this immense volatility between 2017 and 2018, and in the fixed income markets in 2019; one can easily come up with many potential explanations, ranging from the BREXIT crisis in the U.K, the trade conflict between the U.S and China, and a diminishing rate of global economic expansion.
The sheer number of potential explanations for why the U.S stock market may have been so volatile in a given year can be seen as evidence for how much rapid globalization has irrevocably changed the economic and political landscape of the world. No longer can an investor hope to make decisions by keeping informed regarding developments in his own nation; he must now take into account every event of any significance that may take place in even the remotest corner of the world.
This must result in a fundamental shift in how we perceive investing. While we may have been able to feel relatively confident that certain events would occur in the past, such clarity no longer exists. A single tweet sent on a whim by a major politician can now force investors to abandon any projections they may have had for the future.
In a globalized world with exponentially increasing volatility, investors must attempt to diminish the effects of volatility by reducing their reliance on projections.
In markets where a day can mean the difference between a company’s future success and decline, being able to respond to potential threats as quickly as possible has become more valuable than ever before. However, that’s not sufficient to assure long-term success. In a globalized world where threats may come in all shapes and sizes from any corner of the world, investment teams must be diverse enough to make the best decisions they possibly can about the various factors that pose a potential threat or opportunity. In an ocean of volatility, any team sluggish in responding to changes affecting the markets and focused on merely a single aspect of the markets is doomed to be washed away by the rip tides.
But what else can be done in order to survive in the wildly churning ocean of global volatility?
Diversification, one of the hallmarks of Modern Portfolio Theory, is still one of the most important investment strategies in the world of today. Diversification prevents investors from being overly reliant upon a single nation or industry, reducing a substantial amount of risk within their existing portfolio.
However, the merits of diversification should not warrant making any type of investment possible. Despite the fact that all investments are inherently risky, the merits and riskiness of each individual investment should still always be taken into consideration. Another potential benefit of diversification is what many call the diversification premium.
Thanks to the diversification premium, investors can earn significantly more than those who have not diversified their portfolios even though their portfolios may start off with the same average annual return rate. This is primarily due to the fact that diversified portfolios are likely to contain individual investments that yield a better average rate of return than the portfolio average. Such investments allow for the potential downsides of underperforming investments to be entirely offset because their higher than average rate of return will compound in following years providing investors with a “diversification premium” that their undiversified colleagues are unable to receive.
One can argue that investors can best take advantage of such benefits by investing in venture capital firms. VCs expose investors to the type of investments that would not have been included in their portfolios otherwise. This would allow such investors to optimize the diversification of their portfolios by broadening the range of industries and markets in which they invest, providing them with further protection against harmful volatility in an individual industry or market. However, the primary benefit of venture capitalism lies in its direct contribution to helping investors achieve their “diversification premium”.
Despite conducting extensive research on the firms in which they plan to invest, and their respective industries, investments made by VCs are naturally risky, with a promise of high growth and disproportionate returns. When investors couple such high-risk-high-return investments with traditionally more stable investments in their portfolio, they are both able to offset the potential loss or negligible gains on some of the risky investments made by venture capitalists, while at the same time receiving a diversification premium from the few that do end up being successful.
European investors have already adopted such a view. Marking a 42.9% increase from 2014 levels of funding, European VCs raised €8.4 billion, and the median fund size increased by 59.3% to €123.2 million compared to the preceding year. Such a disproportionate increase in funds suggests that the VC industry of Europe, and consequently, its startup environment holds immense potential and will continue to grow, despite what many investors consider to be highly turbulent times not suitable for investing in risky ventures
The volatility we have observed in the past few years is not only here to stay, but it is likely to grow exponentially over the coming years.
Investors can no longer hope to employ old strategies that worked in the past but instead devise new strategies that do not attempt to eliminate the impacts of volatility from their portfolios but use it for their own benefit instead.
Those who embrace this bold new approach to investing, and the role of VC in it, will prosper in the long-run.
by Can Ünlü
with minor contributions from Ali Karabey