As we kick off summer, let’s consider the roller coaster. You hop on, the ride starts and you soar through its ups and downs and twists and turns until you reach the end. Some parts of the ride are slow, some are fast, some are scary and some are fun. Let’s call that Roller Coaster Volatility.
Now, let’s consider Roller Coaster Risks, such as the risk of the cable snapping, the seat belt breaking or the brakes failing. Viewed this way, it’s clear that the ups and downs of the roller coaster are not the same as the risks of the ride. Indeed, most theme park visitors would consider the roller coaster’s volatility to be its key feature.
But Six Flags isn’t Wall Street. Many investors identify risk as market volatility. Rather than seeing the market’s ups and downs as part of the ride, many view volatility as a bad thing. But are risk and volatility one and the same? The path to achieving income and growth goals through an investment portfolio are not the same as volatility of the market.
Volatility is the relatively large and unpredictable movement of the equity market both above and below its permanent uptrend line
says Nick Murray in his May 2015 newsletter article “The Big Bad V Now and Forever” (subscription required). For example, stocks could be up 10% one year and down 50% the next. Bonds on the other hand, may be up 5% in one year and down 1% the next. Bonds typically do not have as big movements as stocks (they are less volatile), but we know that stocks generally outperform bonds over the long term, meaning the higher volatility associated with stocks doesn’t hurt their long-term performance. Volatility is the price you must pay to generate higher returns.
The investment industry uses various financial statistics such as standard deviation to identify volatility or beta to measure volatility. Standard deviation shows how much an investment’s return varies on average over time, while Beta measures the relative volatility of an investment by comparing its variance to the overall market. Put another way, standard deviation tells us how much a particular roller coaster goes up and down while beta tells us how a particular roller coasters ride compares to another roller coaster.
So what is risk? More importantly, what is an investor’s risk?
Risk is the uncertainty of not achieving your goals if there is a permanent loss – either due to the market or more typically, an investor’s emotional reaction to market movements (volatility). In a previous article, we discussed different forms of risk, such as risk capacity, perceived risk and required risk. We emphasized the importance of making decisions about portfolio allocation considering all these elements of risk (your willingness and your ability to take risk) rather than recent market performance up or down (volatility).
The financial industry and media often mixes volatility and risk. Following the 2008 global financial crisis, the industry flooded the market with low-volatility products touting them as less risky products. Before investing in such products, consider the consequences of low volatility products. Returning to our roller coaster analogy, just as a kiddie roller coaster does not give as much pleasure as the faster grown-up roller coasters, low volatility products inherently lower returns compared to the overall market. Also, remember, low volatility by itself does not mean low risk, for example, bonds can be risky too.
The financial industry often portrays volatility as intrinsically bad. But is it? In the last 35 years, the S&P 500’s average intra-year decline was in excess of 14% (with declines ranging from -3% to -48%). And yet, despite these big swings, the S&P 500’s calendar year returns were positive in 27 of the last 35 years (77% of the time).
Source: Standard & Poor’s, FactSet, Fred Graphs, Nick Murray, “Annual End of World Chart”
Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns are from 1980-2014.
The point: volatility could be high or low but volatility is not bad. Volatility could go up or down but by itself, it generally does not hurt an investor’s long-term returns − unless the investor reacts to the volatility. Risk and volatility are not interchangeable.
As you review your portfolio allocation or a new investment, consider your risk and match it to your long term goals rather than focusing solely on an investments volatility. Rather than relying on the up and down of the investment to evaluate risk in your portfolio, it would be more rational and productive to consider your risk capacity, your emotional tolerance for risk and your perception of risk.
Don’t fear volatility! Mixing volatility with risk could make you react to the market which could mean converting a temporary market fluctuation into a permanent loss, and that could result in failing to meet your long-term goals. That’s a risky proposition!
Want to discuss the the state of the markets with GV’s investment pros?
Join us for a free lunchtime investing discussion (lunch provided) on Thursday, July 9 from 12:00pm-1:30pm. Seating is limited for this intimate conversation, so we encourage you to save your seat now.