Life is full of risks and rewards:
You drive your car to work so you don’t have to walk… Reward. You get in an accident along the way… Risk.
Many risks and rewards are, for the most part, clear and measurable. When it comes to investing, however, the situation becomes a bit more obfuscated… and if you know me, then you know that I always look to eschew obfuscation (yep, I just did that).
Investment professionals commonly communicate risk in markets, portfolios, and investments through the use of terms like volatility, variance, and standard deviation…. Each of these refers to how the returns of a market, portfolio, or investment have varied from the historical average.
But how does volatility actually relate to risk? In other words, if I risk having my iPad slung across the room by handing it to a three year-old, then what is the actual situation that volatility presents as a risk to investors? The following is an explanation of some of the actual risks that comes with volatility.
1) Winning by not losing
When thinking of volatility and variance, it’s wise to recognize that returns contribute equally to a volatility metric regardless of whether they’re positive or negative.……higher highs and lower lows = greater volatility.
This is all okay until you consider a real investment and what kind of high the investment must have to offset a previous low. Below is a chart that demonstrates a negative first-year return and the level of return needed in the following year just to break even.
Because the return needed to break even steepens as losses increase, much emphasis should be placed on capital preservation. An uphill climb can severely impair the ability to compound returns, which is one of the key components to building significant wealth.
2) The Effect of Cash Flows
In the real world, investments are made so that they can be sold at a time in the future in order to achieve some kind of goal. The illustration above does not account for whether investors are still in the process of making those investments (contributing) or selling them (withdrawing). The timing of contributions and withdrawals, along with the underlying volatility of an asset, can have a substantial effect on the end value of the portfolio.
As a general rule, when contributions are being regularly made to a portfolio or investment, volatility can be more easily accepted (see Dollar Cost Averaging). When distributions are being made, the opposite is generally true.
When in retirement, an investor may require a fixed withdrawal each month to pay for lifestyle expenses, regardless of the performance of the underlying portfolio. If the dollar amount of the withdrawal is the same, the rate of depletion of the portfolio decreases when performance is good and increases when it is not-so-good. Simply put, if a portfolio declines by 50% and the withdrawal amount remains the same, then the distribution rate would effectively double.
This is why investors nearing retirement typically need to be more judicious about managing volatility, while younger investors with longer time horizons can digest more risk.
Financial Planning Tip: By limiting financial commitments in retirement (like mortgages and car payments) investors can maintain a flexible withdrawal plan that adjusts along with upside and downside volatility. In a situation like 2008-2009, the ability to keep funds invested, rather than being forced to withdraw at the bottom of the market, would have allowed an investor to participate in the bull market of the last six years.
3) Variance Drain
Consider the most extreme example outlined in the “Winning by not Losing” section: if an investment loses 50% in year 1, it will take a 100% return in year 2 just to get back to the initial value of the investment. Conversely, if there is a 100% gain in year 1, a 50% loss in year 2 will erode the entire gain.
When considering this investment, there are two ways to analyze and assess performance:
Arithmetic & Geometric Averages
The arithmetic average is the simple mean return of the investment over a given time frame. In this case:
Without recognizing the order of returns and the effect of compounding, one might think this investment averages 25% return and is a home run. However, as we know from the example above, the ending value is actually the same as what we started with… So shouldn’t returns be zero?
This is where the geometric average comes into play.
The difference between the arithmetic and geometric averages is called thevariance drain. As the variation of returns gets larger, the inaccuracies between these average returns become more pronounced. In other words, when investments, markets, or portfolios swing violently, seeing returns go down the drain is more common (you knew this pun was coming).
Where to Go From Here?
The above examples are reasons why advisers spend time and resources focusing on volatility. (Learning to manage volatility is an entirely different task that will be reserved for another piece.) The most important step to knowing how you should feel about investment risk is to take an account of your financial assets and then assign goals to those assets. Depending on the goal, you may require capital preservation, income, or growth strategies. The course of action is up to you and your financial adviser.
For information or questions write to firstname.lastname@example.org.
Disclosure: The article above is for informational purposes only and should not be considered investment advice. Dollar cost averaging does not guarantee a profit or protect against a loss.