Portfolio volatility is a statistical measure of how much your portfolio value can change over time given price fluctuations of the underlying security holdings. The more technical name for volatility is standard deviation, which is usually reported as a percentage alongside your portfolio return. Your portfolio return is meaningless if you don't know the amount of volatility, or risk, you are taking in order to get that return.
Cumulative Uncertainty Hurts Savers
The cumulative effect of long-term volatility can kill a well-intentioned wealth-building plan even if the annual portfolio volatility is relatively small. Just as compounding returns may (or may not) produce ever-increasing portfolio balances over time, so does cumulative volatility produce the chance of long-term portfolio under-performance, although the likelihood is rare. This rare but severe event which unfolds over a long period of time (think of the first decade of this century) is a killer for retirees when they are on the wrong side of cumulative volatility. This is why we prefer that investors keep part of their savings in non-volatile (lower-risk) assets like guaranteed annuities and Treasury bond ladders.
Please remember that volatility is a double-edged sword. When the market is going up, volatility is your friend and produces "surprises" to the upside. But in a down market, volatility really sucks. And due to both the positive and the negative compounding effects of portfolio returns over time, it is always easier (mathematically) to fix a small gain versus recovering from a big loss.
Visualize Your Volatility Funnel
This week's visual is an educational application called Growth Paths. It's a two-part application which initially shows the viewer a simple, no volatility portfolio compounding returns over 20 years. Optionally, the user can select a starting portfolio value and expected annual return.
The real fun begins when you select the "Include Volatility" check box, which adds volatility to the equation. You can adjust the expected return and standard deviation in real time, noting that the higher the volatility level, the larger the funnel pattern of the eight hypothetical portfolio growth paths at the end of 20 years. This is cumulative uncertainty visualized. And the smaller the volatility level, the narrower the funnel pattern, indicating less uncertainty with respect to long-term portfolio growth forecasting.
If you are interested in experimenting with the Growth Paths application, a video tutorial is available to provide an overview.
In an earlier blog post, we discussed the merits of constructing a well-diversified, low-volatility portfolio that can deliver long-term, stable returns by minimizing volatility per unit of return gained. We did this because we don't know, with any degree of certainty, when volatility is going to help us or hurt us. This is the essence of market timing strategies—getting into the market to capture periods of positive volatility and getting out of the market to avoid negative volatility. There's always a pair of decisions—when to get in and when to get out—that the market timer has to get right, consistently, to earn above average profits. If you know of any portfolio manager who has successfully executed these decision pairs consistently for 20-plus years, then please let me know and I'd be happy to put my personal savings with that individual.
About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself as an "implementer" of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients.
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