May 1, 2017: Debate on Risk vs. Volatility

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Debate on Risk vs. Volatility

We published a subscriber’s email on risk in the previous newsletter April 17, 2017: Risk vs. Volatility: Long Term Stock Market Returns. Recently we received an email from another user on this subject. We publish his email here and make some comments of our own. At minimal, we would like to draw our readers’ attention to start a healthy thought process and/or discussion.

The email:

Hi,

I felt I just had to correct the reader, and you, for publishing his nonsense. It’s funny that he is saying you are spreading bad information to uneducated people, when he himself appears incredibly naïve about investing principles. I’m talking about “variance drain” (aka., volatility gremlins).

In short, he’s absolutely wrong that “By conflating the terms “volatility” and “risk”, you play into the fears of uneducated investors, who should be embracing volatility as the best friend of the long term investor at a young age.”

Volatility is nobody’s friend. Not even at a young age. Even though small caps have higher average returns than large caps, their volatility (if you look at CAGR) makes them a far less attractive investment.

(I’m quoting the work on John Mauldin and Ed Easterling, of Crestmont Research)

“Volatility Gremlins work by tricking you into thinking average returns are the same as compound returns. Here’s an example.

If you experience returns of 5%, -15%, and 25% over three years, your average return over the 3 years is 5% per year. However, your compound return is just 3.7%. Those sneaky Volatility Gremlins snatch away 1.3% per year, or over 25% of your returns! Not so harmless now, eh? Table 1. and Chart 1. show more examples of how a wider disparity (or volatility) in returns results in lower compound returns, even while average returns are constant at 5%. The example above is ‘Case E’ below.

Table 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Chart 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Volatility Gremlins

Please take a look at this link. This concept is eye-opening for many investors, because the Motley Fool and other financial website don’t talk about this at all:

http://www.gestaltu.com/2010/11/volatility-gremlins.html/

But I think it’s an important concept, and I was a little shocked to see your reader’s comments (I’ll bet he has never been through a bear market).

This article above changed the way I invest.

Best regards,

-You Loyal Subscriber

Our comments

As always, we are constantly surprised by the deep insight and experience our customers have. This indicates our customer base is deep (using a currently popular phrase). We thank our readers’ contribution.

Now on the subject, we actually believe both of our readers’ comments do not necessarily conflict with each other. In fact, we stated in the previous newsletter:

Risk and volatility are not the same.
Both should be on a specific period of time horizon.
Volatility is an approximation of risk. It should be with respect to a specific time horizon. To be more precise, one should look at returns in a rolling period.

Specifically,

When investing in a long term (20 years or even longer), interim volatility becomes less relevant. If you are young and if you have new money to invest (such as a young professional who saves periodically), volatility is actually your friend as you can take advantage of that to invest in your new money when markets are low. This is what the previous user’s viewpoint is, we believe.
However, when investing in an intermediate or short term (i.e. 20 years or less), interim volatility becomes more relevant. In fact, it could seriously impact the investment outcome. This is especially true for most investors who are mid ages, near retirement or in retirement. This is what the current user’s viewpoint is.
In the very long term, as demonstrated by the S&P 500 return data we published in the previous newsletter, regardless of what the interim volatility is, the compound returns become more and more converging to a long running mean. Notice in our data, the annualized return is the compound aggregate average, not simple average. So the above data are less relevant to the long term investing. However, we want to point out that even for a long investment horizon, market valuation levels at which new money is invested are an important factor for the returns.
In a short or intermediate term, as demonstrated above, compound returns and simple average are not the same. Simple average return and interim volatility can in fact fool investors to the detriment of the investment returns.

In a word, when you are young and/or invest for a long term (more than 20 years), volatility can be taken advantage of in a Strategic Asset Allocation (SAA) portfolio. However, if your investment horizon is anything shorter than the long term (20 years or less), volatility is probably the biggest enemy one has to deal with. More actively managed portfolios such as Tactical Asset Allocation(TAA) should be employed. It’s thus ultra important to be extremely clear on your investment horizon and the timeframe to need the capital. Don’t be confused by the popular financial media sound bites.

We welcome your comments on this important subject.

Market Overview

Last quarter’s earnings report continue to pour in. At the moment, the earnings growth is better than expected (see Factset’s latest report). It looks like that earnings growth will be the highest since 2011. Investors are encouraged by this short term good news. Risk assets are persistently elevated. As we entering the summer, seasonal weakness can have an effect on stock prices. Nevertheless, the best way for investors to navigate through this period is still the same: stay the course in a well planed strategy.

For more detailed asset trend scores, please refer to 360° Market Overview.

Now that the Trump administration is officially sworn in, the new president is facing the reality to deliver his many promises to make substantial changes. As the nation is posed to invest, the most important factor to watch is how productive the investments will be. Simply put, productive investments will result in better return on investment (ROI), tangibly or intangibly. They should also increase productivity that in turns will improve our standard of living. Capital misallocation can result in a higher growth but might not improve the real standard of living, which is the ultimate goal of economic activities. Whether the new president can truly achieve this goal is still yet to be seen. One thing is certain: we will see more market volatilities.

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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