This blog can sound like a broken record sometimes. We write frequently about how to maximize value from of your advisory fee dollars. The importance of the fiduciary standard is almost a mantra for us. And when it comes to defining risk appropriately, we can’t call-out an enormously overblown association enough: risk and volatility. The reality is that there are only two times volatility matters.
Background: It’s all Harry’s Fault
Harry Markowitz published “Portfolio Selection” as a paper in the March 1952 Journal of Finance. The model’s impact was so extensive on the investment management field that he was awarded the Nobel Prize in Economic Sciences in 1990. In short, Markowitz wanted to show investors how to select investments rationally, based on their portfolios’ combined risk and return characteristics.
Markowitz assumed several things in creating his model, and most of them are unobjectionable. But his first assumption was that portfolio risk is defined as the variability of returns. This assumption commits the logical fallacy known as begging the question – assuming something in order to make an argument, when the thing itself must first be demonstrated. To be clear, Markowitz’s assumption that risk equals volatility was very helpful for conducting mathematically-based academic research. He needed a way to quantify risk.
Today, Markowitz’s question begging is assumed as doctrine by most financial advisors. Unfortunately, because generating attractive relative returns is very difficult, many advisors have flocked to the notion that their job is to minimize volatility. Instead of perpetuating the error, advisors need to answer three questions about risk.
- Which clients equate risk with volatility (not all do)?
- Should advisors play into this understanding, or is it their job to challenge it?
- What is the correct way to think of risk?
We cover question 3 more thoroughly in Debunking Investment Math Myths. For now, we’ll just mention that our preferred definition of risk is: the probability that your assets fail to meet your needs.
None of this is to say volatility doesn’t matter. In fact, we think there are two times when volatility does matter.
1) When it Makes You Nervous
If volatility bothers you, you may not want to invest in assets with widely variable prices. Whether you should worry about volatility is a different matter. A young investor with 20+ years to retirement doesn’t need to be concerned with daily or even yearly volatility. Still you may find that you can’t handle seeing your investment values decline. In that case, choose investments that aren’t as volatile. Just be aware that lower volatility investments may mean that you might also give up return potential. And that might mean you need to save more money to meet your goals.
2) When You’ll Need the Money Soon
Unlike the young investor example above, investors who are about to take money from their portfolios cannot assume short-term volatility. The nightmare scenario is the investor who planed to retire on March 9, 2009, and start spending money from his all stock portfolio when it’s down 50%. Another example is allocating short-term spending needs to volatile assets. If you know you have a $20,000 college tuition payment to make in 6 months, you cannot afford to risk losing that money to short-term price swings.
If price changes aren’t bothersome, or if you don’t need the money for several years, volatility doesn’t need to concern you. In practice this means that assuming more volatility for higher return can be totally rational. The risks of not saving and market timing are far greater than any theoretical rise in price changes.