One of the most important steps to investment success is to understand the concept of risk vs. volatility, while related, they are not the same thing. In fact, it is volatility that creates the opportunity in risk assets, without it, returns would be muted. Volatility is the pricing of future market expectations over the short run. Risk is the probability that an investment or strategy is going to be successful over its stated holding period versus its risk-free expected return. So, how do the two play together in your investment strategy? The three-part simple answer is…the required return, the duration of the strategy and protection against catastrophic loss. These three inputs differ with every client relationship.
As Austin and I are reviewing allocation models, risk vs volatility is what we focus on. Everything has risk, if you had sold your four-season lake home with great lake frontage 20 years ago for $200K and placed that money in a cash-box buried in your back yard hoping to buy a nicer one in 20 yrs…guess what, it is unlikely that you could afford even a small seasonal teardown on the swampy side of that same lake today. During that time, the value of that “cash box” very slowly lost its buying power with no perception of its volatility, while the value of the cabin you had sold fluctuated in price, moving up down with a volatile combination of animal spirits and perceived utility from the marketplace. Where did you have the greatest risk over those 15 years? It was in the erosion of the value of the dollar in relation to the price of lakeshore property. There would have been times during this period in which you would see a lot of volatility in the price of lakeshore property, particularly during the Great Financial Crises of 2007-2009, you would have been thankful that you had sold that property, but over time, you would probably come to regret it. Moral of this story is that while the “cashbox” would have shown very little volatility, it would have proven to have more financial risk over time due to its inability to provide a “like-kind” property 20 years later.
I like to use real estate because it is tangible, and price volatility is not readily available. You don’t get a monthly statement telling you how well your house performed last month. With investments, you do see evidence of volatility every time you view your online account or read your portfolio statement; right there, on the front page you were +/- $xxxxx this month. According to Prospect Theory, if you are a normal and sane individual, it is much more eye-catching when that number is a loss. The bigger that number, the greater your volatility over that period, this is not always a good measure of the objective risk of your portfolio. It is by owning various types of volatile assets that increases the probability we can meet your longer-term investment objective. Without these varying volatile assets, we run the greater risk of eroding your purchasing power and decreasing the probability that you will meet the goals you have described to us. We care deeply about your success and take very seriously the task you have burdened us with. Please do not hesitate to reach out to us at any time to discuss.
- Dave
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. 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.