Why Volatility (and Roller Coasters) Are Best Suited for the Young in Years Rather than the Young at Heart
I used to love roller coasters. The rush of adrenaline and fear was intoxicating, especially since in the back of my mind I always knew both that it would all be over in a few minutes and the odds were pretty strong that I’d live to tell. These days, this brief burst of joy isn’t worth the potential backache, nor that queasy feeling that just might lead to a chance reunion with what I had for lunch. While I haven’t completely lost my need for speed, I’ve learned to channel these urges into activities that both make for a more enjoyable ride and a far more pleasant aftermath.
I look at investment volatility in the same way – it’s decidedly a young man game. Or, more precisely, it’s something best suited for someone who has the time, risk tolerance and patience to wait for the roller coaster regain previous heights after that terrifying near-death feeling that accompanies that sickening downward plunge. Simply put, younger investors socking away money for retirement (as well as older investors living exclusively off their income rather than capital) have the time to wait out the ups and downs while chasing the higher potential returns that can go along with higher volatility investments if their investment acumen and good fortune align.
When investing, the basic premise seems to be that, by taking on more volatility and risk, you’ll do better in the long run. Although that certainly may be the case, the worse can also be true – you also have a bigger chance of things going horribly wrong. Volatility just means that you have a better chance of having an internal rate of return on your portfolio markedly higher or lower than the average. And which end of the stick you end up on actually depends a lot more on luck than perhaps the investment industry might wish you to believe.
It seems to be a common belief that more volatile investments will always provide you with more money over the long term because they might have higher “average rates of return”, which is perhaps the most common statistic used to weigh past investment performance. In other words, it is easy to believe that since more volatile asset classes or assets may a higher average rate of return over the long term, that you’ll always win in the end. Unfortunately, the average rate of return is virtually useless in measuring whether your specific portfolio will make money (or how much) over the long term . . . or even if past investors did so! Just because the average rate of return over 10 years may have been 7%, this not enough information to tell you whether or not someone who invested $1,000 dollars ten years ago actually has more or less money than when they started.
Consider this example – your broker tells you that your original $100,000 investment has generated an average rate of return of 0% over two years, net of costs. Common wisdom would suggest that the investor would be able to call his broker at the two-year mark and withdraw $100,000 the next morning. On the other hand, pretend his $100,000 portfolio loses 40% in year one but makes 40% the next year. This result would produce a 0% average rate of return but our poor investor would still be down $16,000 or with an internal rate of return of -8% per year! This is because losing 40% of $100,000 has a far bigger impact on his bottom line (i.e. minus $40,000) than earning 40% on $60,000 the next year (i.e. plus $24,000).
In reality, the “sequence of returns” or the order of your good or bad years has a lot more to do with whether your portfolio will make money than the average rate of return. Even more dismaying, the higher the volatility of your portfolio, the less useful the average rate of return will be in telling you whether (and by how much) your portfolio actually gained or lost. Thus, when comparing portfolios that have different levels of volatility, looking at the average rates of return between them is like comparing apples to oranges. Even if the higher volatility portfolio may have made more money over the long term (and this is not a given, as we’ve just seen), it may have exposed you to far more risk to do so. Accordingly, if the goal of retirement investing is to avoid financial ruin, taking on a portfolio with slightly lower past returns but significantly lower volatility (often measured as “standard deviation”) may ultimately be a far better decision.
By the way, if you’re looking at a meaningful statistic to measure past performance, look at the “compound average rate of return” or simply cut to the chase and compare the examples now commonly given on investment statements that show the current value of an original $1,000 investment compared to how similar investments have performed over the same time period. For those worried about large withdrawals or deposits skewing the results, look into “money-weighted returns” that is a lot like the internal rate of return I mentioned earlier but it takes into account when money goes in and out of the portfolio.
Returning to importance of the sequence of returns, the best way to see their impact is by way of example, first produced by Associate Professor Moshe Milevsky, who is recognized in Canada as perhaps the expert on retirement math. Assume there are five investors, all of whom just turned 65 and have $100,000 portfolios with a 7% average rate of return, from which each investor withdraws $750 per month until the portfolio has been depleted. The baseline portfolio earns a constant 7% per year, while the other four portfolios use a repeating three-year cycle that also average 7% but with gets there by earning 7% in one year, 27% in another and -13% in the third, although each of the four alternative portfolios varies the order or sequence of the good and bad years as follows:
Scenario A 7%, -13%, 27%;
Scenario B 7%, 27%, -13%;
Scenario C -13%, 7%, 27%; and
Scenario D 27%, 7%, -13%;
Ultimately, the results for the 5 examples varied wildly. While the “Steady-Eddy” fixed 7% return client had enough money to last until age 86.5, a client unfortunate enough to hit retirement just when the markets were about to crater (Scenario C) ran out of money a full 5 years sooner, while someone who retired a year later and had the same size beginning portfolio would have enough money to last until she was over 94 years of age! In other words, by simply varying the order in which the market had good and bad years, the sample client’s retirement was either one where he was out of cash as early as age 81 or still with money in the bank at age 94!
Thinking about this in practical terms, there are a few lessons to take away from this example. First, volatility is even more impactful when an investor is in retirement and using their savings to pay the bills rather than just living on the interest, dividends and other types of income the portfolio might produce. In other words, the effects of volatility are magnified when retirees are forced to sell low in order to put food on the table. Having to sell a stock when it is down 20% from the year means the following:
- You are essentially experiencing a 25% cost of living adjustment for that year, as the groceries you could have bought last year for $100 by selling 4 shares worth $25 each now require you to sell 5 shares now valued at $20. Thus, you had to sell 5 rather than 4 shares to buy your Special K and Hamburger Helper.
- By selling that extra share, you also lose the dividends on that share, which means having to sell more shares in the future in order pay for future groceries since the less income generated from the remaining portfolio, the more capital that needs to be sold to pay the bills. This, in turn, will further reduce the income produced by the portfolio so that effects of having to sell that extra share in this year will continue to snowball into the future.
- There is one less share to benefit when the stock market bounces back, which means that the rest of the portfolio would have to grow by that much more in order to make up lost ground.
Thus, putting this all together, the message is clear: while the sequence of returns is important to all investors, it’s even more vital to those in retirement who are drawing down their capital. Accordingly, my message to clients approaching retirement on track to hit their financial goals is a simple one – volatility is not your friend. Owning a portfolio with less volatility, even if it means potentially leaving money on the table during times when the market roars, is far more important than chasing after investment gains that you simply do not need when the consequences of things going wrong can be catastrophic.
Although it is time to wrap things up for now, I do want to end things on a more positive note that the dire words and somber tone of the preceding paragraphs. In writing this article, I realized that I have a lot more to say. As a result, be forewarned – I plan on writing a series on investing during retirement that will be far more focused on the happy ending. Rather than telling you what can go wrong, I would much rather talk about what you can do to make things go right. And there are many steps you can take. But that is a story for another day.