RISK is a fundamental component in investing – but what actually IS risk? Most people identify it as the chance that they will lose money when they invest. But really, in order to actually lose money, the investment must be either sold, or it must actually lose 100% of its value. Holding onto an investment portfolio, and diversifying even a little, leaves very little chance investing will result in an actual permanent LOSS. If an investment goes down in value, there’s always a chance it might go back up. Still, it’s that very drop in value that most investors are referring to when they talk about risk.
So perhaps VOLATILITY is a better measure of risk. Indeed, volatility – or ‘variation’ of returns – is what most investment advisors use to quantify risk (actually, for the statistics geeks, the square of the variation, known as ‘standard deviation’ is what we really use.) But even that doesn’t line up perfectly with how most investors define risk. People actually only consider half of variation to be actual ‘risk’; I’ve never received a concerned call from a client whose investments have recently suffered from a jarring UP-swing.
Given that volatility (at least the downside) is generally considered such a bother, it might be helpful know that:
VOLATILITY IS A GOOD THING. Here’s why:
- We’re compensated for taking on volatility. Think about it this way: Where can we put our money and not worry about volatility? A bank? What if I want to earn $1/year on a bank account? Assuming a savings account is going to give me about 0.5% interest, I’ll need to deposit $200 into the bank for that return. Right now, in order to buy $1 worth of earnings in the stock of a large US company, I only need to plunk down about $16. I pay less for those earnings, why? Volatility! If stocks were no longer volatile, their prices would go way up – maybe to the point where I had to pay $200 for a dollar’s worth on earnings. And then my ‘earnings yield’ would be 0.5% like the savings account. Simply put, without the volatility, we don’t earn nearly as much over the long term.
- Volatility creates opportunities. One such opportunity is something called “Dollar Cost Averaging”, which is investment-speak for putting money to work in an investment in a set amount on a regular basis (monthly, weekly, whatever). When we do that, we automatically create an environment where we purchase more shares of an investment when the price is low and fewer shares when the price spikes upward. Generally, buying more cheap shares and fewer expensive shares is considered prudent.
- Volatility keeps some people away from the market. Banker, Businessman and Treasury Secretary Andrew Mellon once referred to recessions as periods when “assets return to their rightful owners”. Day-traders, speculators and gamblers often are knocked out of the markets during volatile periods, leaving the upside to be enjoyed by the patient investors who ride out these upsets.
Before you head out to find some volatility, though, you should keep another thing in mind:
VOLATILITY IS A BAD THING: Here’s why:
- Volatility leads smart people to do dumb things. A study by Dalbar, now in its 25th revision, shows a steady, predictable pattern: Investors do poorly relative to the market as a whole. Simply put, we humans get too eager to purchase investments when it feels good (when they’ve been going UP) and are too eager to sell when it feels bad (when they’re cratering). Taking on volatility, without the long-term courage of your convictions, lands you in a high level of probability that the end results will not be as good as they could be.
- Downside movements have a bigger impact than upside. Looking way back, whoever invented math was quite cruel. If an investment goes down by 25%, you don’t get back to even with a 25% increase in value. You actually need over 33% to recover. Down 50%? You need 100% return to get back to even! Downside volatility hurts more than upside volatility helps.
- More evidence that math people are cruel. Take the three following sequences of annual returns:
Notice that for all three of them, if you consider their average annual return, they all come out to the same number: 5%. But notice that Portfolio A had no variation in returns, Portfolio B had a little variation, and Portfolio C had a good bit of variation. When we consider the compounding effect of interest over time, we get to an interesting mathematical law: Given multiple sequences of returns with the same ‘arithmetic average’, the sequence with the highest compounded rate of return will ALWAYS be the sequence with the lowest ‘standard deviation’ (or lowest variability).
Volatility could very well be a lot like the drugs advertised on TV. You definitely need some of this medicine, but you must be careful not to take more than you need and you need to be aware of the side effects. Essentially, as volatility goes, we’re looking for what doctors call the M.E.D., or “Minimum Effective Dosage”. Take on volatility for its positive attributes, but take no more than you need!