Numerous factors impact the health and vitality of the human body on any given day; the same is true with investing, numerous factors impact daily market performance. Information can change hourly. Similar to medicine, striving to craft the winning investment formula changes and improves based on advances in research. But despite what market forecasters may tell you, stumbling across a “one size fits all situations and timelines” solution is highly unlikely. The common solution lies in risk management. However, we regularly overlook its essential counterpart: Volatility management, an uncommon strategy that can’t be ignored.
Risk vs. Volatility: What’s The Impact?
Investing involves risk. And higher risk doesn’t mean higher return; it just means an increased uncertainty of loss, and does little to drive returns. Why, then, is risk management thought to be the end all portfolio booster?
The problem is that we don’t fully understand how risk and volatility impact our wealth. While these terms are common among investors, it’s important to note that they are not one in the same. Risk doesn’t necessarily drive returns; it just moves the probability of losing money up and down. Volatility refers to the amount of fluctuation in actual returns from year to year; in other words, volatility has a larger influence on returns. Highly diversified and strategically allocated portfolios can still experience steep rides on the volatility roller coaster.
For example: If you had a diversified portfolio of stocks and bonds that experienced a 50% drop, how much does it need to gain to get back to its original value? If you guessed 50%, you’re wrong. It takes a 100% gain to make up a 50% loss. While this illustration uses figures for the sake of numbers, this is a prime example of how spikes in volatility can impact your wealth. And what if these spikes happen at exactly the wrong moment? Will your wealth have time to catch up? What about its retirement longevity?
The Two Major Retirement Risks
There are two major types of risk that can impact your retirement: Sequence of Return Risk and Longevity Risk. While traditional risk management can mitigate the impacts of general market risk, it can fall miles short in protecting you against these two factors. Why? They are driven by volatility.
Sequence of Returns Risk
The market is going to up and down, that’s what we can guarantee. What we can’t guarantee is when the market is going to go up and down. It’s not just the amount of volatility a portfolio may experience that is crucial, but when that volatility occurs. Refer back to our previous example: Now, if a physician in their late twenties or early thirties experienced a steep decline, chances are their wealth would have enough time to recover. But what if a physician in their sixties experienced the same decline? What if a newly retired physician experienced it?
Here’s another way to look at this: Compound interest can play a big role in wealth accumulation. An updated view on this would be the law of uninterrupted compounding. Your wealth’s ability to compound works to its greatest advantage when it’s not interrupted. Now, we can’t avoid interruptions in the market, but volatility management can help you avoid large losses and mitigate their impact. This should be your main goal.
This is what keeps all of us up at night: The likelihood of outliving your money. No one knows how long your retirement will last; the longer it lasts, the more money you need, and the increased probability of experiencing extra spikes in volatility. Since your income will be comprised of your assets in retirement, the traditional technique is preserve first. While important, this can cause retirees to invest more conservatively, simultaneously diminishing your returns, which isn’t ideal.
Producing favorable returns means taking a higher amount of risk with a portion of your portfolio, even in retirement. And taking a steep ride on the volatility roller-coaster can mean that you’ll probably experience the decline, but not the recovery. Volatility can increase your chances of having to withdraw from the portfolio while it’s down. To cover living expenses, you may have to dip into the principal, selling holdings that would’ve had a chance to rebound. Remember our main goal: Avoid large spikes in volatility.
Average Returns vs. Compound Returns: What’s Yours to Keep?
We also need to understand the role that average and compound returns play in investing, and their place in volatility management.
These are calculated just like any other average: the numbers are added together and divided over a certain amount of time. So, if the market has an average return of 7%*, that means we should all be sitting pretty come retirement, right? Wrong, because your wealth will more than likely not compound at that rate. You can’t take home average returns. This is why average rates of return can be sneaky misleaders.
These are the returns that a fund produces on an annual basis, and will more than likely vary from year to year. These variations are what make up the average return. As volatility increases, the compound return can dive lower and lower compared to the fund’s average return. Why is this important? Compound returns are what you take home. This is why even if the market averages 7%*, many of us have a substantial chance of sitting anything but pretty as retirement approaches.
Volatility Management: Essential for Safeguarding Your Retirement
Risk is the likelihood of losing money. Volatility is the amount of fluctuation in a portfolio’s returns. Compound returns represent these fluctuations in hard numbers. Average returns are made up of years’ worth of fluctuations. We take home compound returns. We can’t take home average returns.
These brief facts are what we’ve discovered here together in a nutshell. Thus, reiterating the fact that while risk management is important, the addition of volatility management is often the missing component. Volatility is what drives compound returns, and compound returns are what grow or diminish our wealth. Therefore, an investment strategy built for risk management and downside risk protection (avoiding large losses) is an essential defensive strategy in safeguarding your retirement.