The Fall has ushered in both unpredictable weather and unpredictable volatility. While protection from adverse market events is best if in place prior to volatility spikes, it’s not too late to batten down the hatches.
However, before investors take steps to reduce volatility in their portfolios, they must believe that volatility is something to be avoided. We’ve heard market pundits say that volatility isn’t ‘risk’ because risk is the permanent loss of capital. However, the fact is that the higher the volatility of an asset, the greater the uncertainty around its value when you need to sell it.
Volatility is problematic for two reasons. First, there is the psychology of losing money; even professional investors are susceptible to making ill-timed decisions in the face of losses. Investors who bail when times get tough typically reinvest too late into a recovery.
The other reason volatility is problematic is its effect on compounding. Two assets with the same average return will have different compound returns if their volatilities differ. In the table below, you’ll see that both investments have an average return of 10% over the five-year period, but Investment A, which has no volatility, compounds at 10%, while Investment B, which has a standard deviation of 16.9%, compounds at 8.9%. Compounding can have a huge impact on an investment’s result, potentially adding years until one is able to retire.
While we may not be able to suppress our innate behavioral tendencies, nor change the mathematics of compounding, we can actively implement strategies that seek to dampen volatility, thus mitigating the damage it can cause.
There is a myriad of ways to brace for continued higher volatility. Strategies include buying options or Treasuries, or adding to cash, but each of those approaches requires effective timing.
Alternatively, allocating away from long-only equity strategies in favor of a long-short combination offers greater risk management and the potential for increased alpha generation. (It’s worth noting that long-short equity strategies lost about 20% on average during the financial crisis, which, while painful, was a far cry from the losses of 50% or more experienced by many equity indexes.)
Over a lifetime of investing, volatility will make a significant difference in your clients’ net worth, so taking the time to prepare for it now is well worth the effort.
Read more in our latest blog, Broken Records: Earnings Strong, but Sentiment Weak >