There seem there are two extremes when it comes to investing. Those investors panic the first minute we experience a down day. Others are not phased at all since, after all, the market always bounces right back.
Both investor sentiments are valid, but like everything else in life, there is a lot of grey in between. The markets go up and down, and it is never a straight line. There are always fluctuations – we call that volatility. But to ignore volatility would be missing an important fact. While investors may be able to overcome the fact that volatility is not suitable for the psyche and can cause bad behavior (investors selling at the worst time), volatility can cause actual losses and result in less money over time.
In this discussion, we would like to walk you through some examples of how this happens.
Understanding Market Risk and Volatility
The following example demonstrates why investors should learn how to manage their portfolios’ exposure to the volatility inherent in the markets:
Steady Eddie understands how volatility will cost him money and is careful to manage it.
Fast Frances, on the other hand, doesn’t view volatility as a problem. She believes that she should invest aggressively. Frances understands that the markets are volatile, and she is in it for the long run.
She is not afraid to ride the volatility because she knows that the markets tend to go up in the long run so that she can recoup losses.
Note below how Steady Eddie’s portfolio performed compared to Fast Frances’s.
Both have $100,000 to invest. Steady Eddie invests in an asset allocation that delivers an average annual return of 10 percent.
Fast Frances is going to go for the ride. She can also achieve a 10 percent average return, but she will experience more swings from year to year.
But when reviewing the performance of a portfolio, another statistic should be considered. In statistics, the standard deviation is the variance of a given data set from the mean. The charts for Steady Eddie and Fast Francis below should help explain. The average return for both investors is 10 percent, shown by the straight line on each graph. The jagged lines connecting each point depict the actual individual returns for each year. The bumpier the line is, the more the actual returns deviated from the portfolio average. These wide deviations created more profound swings in Fast Frances’ portfolio than Steady Eddie’s. The standard deviation calculates volatility by comparing each actual return (the points/jagged line) with the average (straight line). This calculation resulted in Steady Eddie’s having a standard deviation of 4.5 percent and Fast Frances’s, having a standard deviation of 18.5 percent.
OK, you say, big deal. They averaged the same annual return, so what is the harm if Fast Frances wants to ride the volatility?
The following chart shows the actual annual returns and the calculated dollar value of each portfolio at the end of each year and after ten years. Even though both investors received the same average yearly returns, Steady Eddie’s portfolio has grown more after ten years.
Steady Eddie’s portfolio is $40,000 greater than Fast Frances’. Isn’t that the goal — not just a higher average return, but more real cash? This is because of the math of compounding, the effects of volatility on total returns, and managing risk to minimize volatility.
Keep these points in mind:
- Risk can be measured using statistics. Investors should know their portfolio’s average return and their portfolio’s standard deviation.
- The impact of volatility becomes more significant as time goes on, so if this exercise were carried out for another ten years, the difference between the two portfolios would grow exponentially wider.
- You must take some risks to get investment returns, but intelligent and not-so-smart risks can result in damage.
- The damage is in real dollars.
- With this economic damage comes emotional damage and general angst.
The good news is that the volatility you can deal with and still sleep at night can be determined by assessing your tolerance for investment risk. Once you choose this, you don’t want to get into investments whose risks exceed your tolerance. And you want to be sure that you’re compensated for the risks you are willing to take with a higher average return. This way, volatility likely won’t impair the performance of your portfolio more than you’re psychologically equipped to deal with.
You may view this and the rest of our videos on our YouTube channel, “Its Your Smarter Money,'” Hosted by Atlas Fiduciary: