Investment risk is complicated. It includes the risk that earnings fall, margins collapse, tenants leave, interest costs rise, debt cannot be refinanced, an asset needs unexpected expenditure, or that you simply paid too much in the first place. Yet much of the investment industry boils all of this down to one number: price volatility.
There is a good reason for that. Price volatility is measurable. We can take a series of prices, calculate the variation in returns and compare one investment with another. The problem comes when a useful measure becomes the measure of risk.
Because once investors, regulators and investment managers start judging portfolios using price volatility, there is an obvious incentive to own assets where the price does not appear to move very much. And one of the easiest ways to reduce measured volatility is simply to measure the price less often.
Unlisted Assets vs Listed Markets: How Infrequent Valuations Hide Risk
Consider two airports. One is listed on the sharemarket. Its price changes every day as investors react to passenger numbers, interest rates, economic conditions and new information.
The other is held in an unlisted fund. It might receive a formal valuation quarterly, six-monthly or annually. That valuation will usually be based on discounted cash flows, comparable transactions and other assumptions.
The listed airport will almost certainly show much higher measured price volatility. But does that mean the underlying airport is actually more risky?
Of course not. The same economic forces affect both airports. The difference is that one has its changing value continuously exposed by a market price while the other has those changes filtered through an appraisal process.
Residential property provides an even simpler example. If you absolutely had to sell your house this week, perhaps three buyers would compete for it. If you ran the same auction next week, two of those buyers might have purchased somewhere else and the remaining bid might be 10% lower. Did the economic risk of the house suddenly change by 10%?
No. What changed was the price available at that particular point in time. Listed markets reveal that uncertainty constantly. Property and other unlisted assets tend to hide it.
There are legitimate reasons to use long-term valuations. A distressed transaction today does not necessarily tell you what an airport, office building or toll road is worth to a long-term owner. But we should not confuse a smoothly reported price with a low-risk asset.
And this becomes particularly important when investment funds are judged partly on reported volatility. If an asset that is valued infrequently produces a smoother return series, then a portfolio can appear to have lower risk without the underlying economic risks being any lower. Whether deliberate or not, the system creates an opportunity to game the risk measure.
The cost is not just theoretical
The problem becomes much more serious in superannuation because members are entering and leaving funds at the reported unit price. If an unlisted asset is being carried at $100 when a reasonable current value is actually $90, a member who withdraws at $100 receives more than their fair share. The loss does not disappear; it is effectively transferred to the members who remain.
That is roughly what APRA identified at HESTA during the extreme market conditions of March 2020. Some investment options containing unlisted assets were revalued before other options holding the same assets. Members transacting during that gap therefore received different prices for effectively the same underlying investments. APRA said that in one case a member was approximately $17,000 worse off.
This is an important illustration of why low reported volatility is not necessarily a virtue. Sometimes it simply means that reality has not yet made its way into the reported price.
Cash-Flow Risk Explained: Why Shares Offer Better Downside Protection Than Property
There is another major part of investment risk that volatility statistics can miss: cash-flow volatility.
Take a residential investment property earning $4,000 a month in rent. Suppose a tenant badly damages the property. It is vacant for three months and requires $10,000 of repairs.
You have lost:
- $12,000 of rent; and
- $10,000 in repairs.
That is a $22,000 cash-flow hit before even considering interest, rates, insurance or other expenses. Annual rent that would normally have been $48,000 has effectively fallen to $26,000 before those other costs.
This highlights an important distinction between directly owning an asset and owning shares in a company.
If you own the house, its cash flows can be positive or negative. If the roof needs replacing, you pay for it. If the property is empty, you still pay the interest and rates. If the plumbing fails, that is your bill.
An ordinary shareholder has limited liability. A company can cut its dividend to zero. Its profits can disappear. Its share price can collapse. But, absent leverage or some unusual contractual arrangement, the company cannot normally send shareholders a bill saying: “The factory roof needs replacing. Please transfer your share of the repair cost by Friday.”
The shareholder’s distribution can fall to zero, but the shareholder is generally not required to fund the company’s ongoing operating losses. That puts an important floor underneath the cash flow from ownership.
It does not make shares risk-free. Far from it. But it substantially changes the range of possible cash-flow outcomes compared with owning an individual property, business or other asset directly. i.e. it is likely that owning the unlisted airport actually gives you considerably more cashflow risk than owning shares in a listed airport.
Diversification changes both types of risk
This brings us to the biggest missing piece in many comparisons between assets: diversification.
There are really two benefits.
1. More assets means individual problems matter less
Go back to the damaged rental property. If you own one property, losing $22,000 is a major financial event. If you own 100 properties and one suffers the same problem, the impact on the total portfolio is comparatively small.
The same principle applies to shares. A company might lose its biggest customer, suffer a cyberattack, have a product failure or cut its dividend. If it represents your entire portfolio, that is disastrous. If it is one of 40 or 100 holdings, the damage is much more manageable.
This applies to price volatility as well. As few as 10 stocks probably would reduce your volatility by a quarter to a third. Adding further holdings continues to help, although the benefits gradually diminish because market-wide risks cannot be diversified away.
The first few additions do the most work. The important point is not whether the exact answer is 14%, 15% or 16%. It is that owning one asset is fundamentally different from owning a diversified portfolio of assets.
2. Different assets are hit by different things
There is another level to diversification that is just as important.
Owning 100 residential properties is clearly better diversified than owning one. But all 100 properties are still exposed to many of the same forces:
- Australian interest rates;
- Australian employment;
- Australian credit conditions;
- housing regulation;
- local property taxes;
- construction costs; and
- the Australian residential property cycle.
You have diversified the individual-property risk, but you have not diversified the economic risk nearly as much.
A portfolio spread across different industries and different countries goes much further. A US pharmaceutical company, a Japanese industrial manufacturer, a European consumer brand and a Taiwanese semiconductor company are exposed to very different customers, currencies and economic forces.
Some risks will still affect all of them. A global recession can hit almost everything. But many of the things that hurt one company, sector or country will have little effect on another.
So diversification works twice: first, by increasing the number of individual assets, and second, by spreading those assets across different sources of economic risk.
Look at dividends rather than share prices
This distinction becomes particularly interesting when we look at cash flows from a diversified share portfolio rather than its market price.
Individual share prices are volatile. Individual company dividends can also be volatile. But aggregate dividends across a diversified global portfolio are surprisingly stable.
The market price reflects constantly changing expectations about everything that might happen over the next 10, 20 or 30 years. Dividends reflect the cash companies are actually distributing today. Those are very different things.
Over the last half-century, there have been remarkably few years in which total annual dividends from the S&P 500 have fallen. And even during some of the worst economic and financial shocks of modern times, the decline in dividends was far smaller than the decline in share prices.
Approximately:
- COVID: share prices fell around 20%; dividends around 2%.
- Global Financial Crisis: share prices fell around 40%; dividends around 20%.
- Tech wreck: share prices fell around 30%; dividends around 6%.
Even the Global Financial Crisis — by far the worst of these episodes for dividends — was relatively short lived. First, dividends spiked higher just before they dropped. Even still, by around 2010, aggregate dividends were roughly back around their 2006 level.
That is an extraordinary difference.
Someone watching the market price during a crisis sees enormous volatility. Someone looking at the aggregate cash being generated and distributed by hundreds of companies sees something much more stable.
This does not mean dividends are guaranteed. It means diversification can turn a collection of individually volatile cash flows into a much more stable portfolio-level cash flow.
That matters enormously when thinking about risk. A well-diversified global share portfolio might have a quoted market value that moves 15–20% in a difficult year while the underlying dividend income moves only a fraction of that amount. If your investment horizon is long and you do not need to sell, which of those two numbers tells you more about your actual financial risk?
The answer is not always the share price.
Australia is a good example of why diversification needs to be global
Australian dividends tell a different story. They are considerably more volatile than US or global dividends, largely because of the composition of our market.
Australia has an unusually large exposure to banks and resources. Resource companies tend to generate enormous cash flows when commodity prices are high and then cut distributions aggressively when the cycle turns. Banks usually provide relatively stable dividends, but a sufficiently large financial shock can affect most of them at the same time.
During COVID, Australian dividends fell by roughly 35%. During the Financial Crisis the fall was around 25%. Interestingly, during the tech wreck Australian dividends actually increased, as the old-economy banks and resources companies were relatively insulated from what was happening in technology shares.
That last example is actually the point. Different sectors suffer at different times. Different countries suffer at different times.
A portfolio concentrated in Australian shares can contain dozens of companies and still have significant exposure to the same underlying economic drivers. True diversification is about more than counting the number of holdings.
How to Measure True Investment Risk Beyond Price Volatility
Price volatility is useful. But it is one measurement of one aspect of risk.
A better way to think about an investment portfolio is to ask three separate questions.
How volatile is the price? And importantly: is that price genuinely observable, or is it being estimated through an appraisal process?
How volatile are the cash flows? Can income disappear? Can costs exceed income? Can the owner be required to inject additional capital?
How diversified are those risks? Do you own one asset or many? Are they all exposed to the same economic forces, or spread across different industries, countries and sources of return?
Seen through that lens, some traditional comparisons start to look very different.
A single residential property may show almost no measured monthly price volatility, yet have substantial cash-flow risk, concentration risk and liquidity risk. A diversified global share portfolio may display a frightening amount of price movement every day, while the aggregate profits and dividends generated by the underlying companies are considerably more stable.
Neither observation tells us which asset will produce the higher return. But it does tell us something important about how we should measure risk.
A smooth price does not necessarily mean a safe investment.
Sometimes it just means nobody has asked for a real price lately.
And one of the most powerful ways to reduce genuine investment risk — both in prices and in cash flows — remains the simplest one: diversify across more assets, more industries and more markets.
That is also one of the advantages of a globally diversified Direct Indexing portfolio. You can own the underlying companies directly, see exactly what you own, and spread both company-specific and cash-flow risk across a broad range of businesses.
The portfolio price will still move. That is not a defect. It is often simply the market showing you risks that other investment structures allow you to pretend are not there.
Understanding true investment risk—from cash-flow stability to global diversification—is essential for protecting and growing your wealth long term. If you want to build a portfolio designed to handle market fluctuations with transparent, direct asset ownership, book a meeting with our team to discuss how Nucleus Wealth can help tailor a solution to your financial goals.
