Confusing Volatility and Risk

I believe it is imperative for investors to understand the difference between volatility and risk. Though often used synonymously, these are two very distinct ideas. We think success can be increased by clearly understanding the distinction between these financial principles. Let’s start by taking a look at risk.

We define risk as the loss of purchasing power of an investor’s capital over time. This total equation accounts for more than simply the growth of an investor’s money, say from $100 to $110, but also accounts for the loss in purchasing power of that money over the same time period due to inflation. Over a period of ten years with a 3% inflation rate, that $110 would be worth LESS than the original $100 the investor started with! So often investors consider only one half of this equation, without accounting for the risk associated with inflation and the loss of purchasing power.

This is a challenge every investor faces. When money sits in a bank account earning less than 1% interest as it has been for recent history, wealth IS NOT increasing. Instead the true value of that money is decreasing by 2% year-over-year thanks to a historically typical 3% inflation rate. Make no mistake, when your money buys less goods and services over time, it is a risk to your long term success.

Volatility is the often cyclical, ups and downs of market prices. Volatility is the wiggle, and the market always wiggles. Therefore we consider volatility to be a normal and necessary piece of investing. It should not be feared, nor should it cause panic. Yet in my experience, investors are often scared out of intelligent investments or long-term financial plans by what the market is temporarily doing.

It is easy to understand why everyone would want less volatility – if that’s all there were to it. But decreasing volatility brings about a serious negative consequence. In my experience, low volatility leads to low return. Less return necessitates one of three things: more upfront principal, lower withdrawal rates, or simply running out of money.

Consider the historical data from three asset classes (small companies, large companies, and bonds) from 1926 through 2013. Small companies returned an average of 12%, large companies 10%, and bonds 6% (A Random Walk Down Wall Street, Malkiel). If our typical inflation headwind is 3%, we can subtract 3% from each of those returns bringing their respective returns down to 9%, 7% and 3% respectively. The rate an investor will experience is often directly inverse to their desired levels of volatility. Bonds wiggle less than stocks, so they often return less than stocks. Those who ride the roller coaster experience higher highs (and lower lows) than those who stick to the merry-go-round.

Less volatility means less return. Less return means you either need to work longer, spend less or run out of money before you run out of time.

Small Companies

Large Companies

High Quality Long Term Bonds

12%

-3%

9%

10%

-3%

7%

6%

-3%

3%

So what’s an investor to do? Start by keeping a few things in mind:

  1. Volatility is merely a synonym for unpredictability. Volatility simply refers to the relatively large and unpredictable movements of the equity markets both above and below its’ permanent long term uptrend line.
  2. The premium return of equities therefore are an efficient market’s way of pricing adequate compensation for tolerating premium unpredictability. Paying investors for unpredictability.
  3. Seeking less volatility leads to a commensurate less return.
  4. Think about equities as the potential to advance. This statement is based on history. With a long enough time horizon, the markets have historically gone up.
  5. If accumulating investments, applaud volatility. By continually investing systematically, investors buy more shares when prices are low, and fewer shares when prices are high.
  6. The only investors who might be genuinely harmed by volatility are those approaching or recently starting retirement. We have strategies to bridge the risk such as 1 -2 years of your forecast budget in low risk strategies.

Volatility is not always synonymous with risk. In a properly diversified portfolio temporary declines are just that, temporary. The key is finding a balance between appropriate levels of volatility and the risk that comes from locking money away and having it slowly erode due to inflation. We seek to find that balance and put it to work for you. If you’d like more information on our strategies or what we can do to help you, please give us a call.

Steve Booren

Steve Booren

Steve started his investment career in 1978 with the NYSE investment firm EF Hutton, working in the environment of a large investment company. Desiring to provide clients with objective investment advice, he founded Prosperion Financial Advisors. Learn more about Steve here.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. No strategy assures success or protects against loss. All indices are unmanaged and may not be invested into directly.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.


Sources:
Inspired by Nick Murray May 2015, “The Big, Bad V”