Weekly Insight: Why Volatility Matters

If you learn one thing from our newsletter this year, I hope it will be the concept of today’s issue. I have come to believe that volatility is one of the most underappreciated aspects of investing. Everyone likes to focus on rates of returns, but the volatility of a portfolio can be equally important. How much volatility should you expose yourself to? The answer lies primarily in your investment time horizon. In other words, how long will it be until you withdraw some or all of the money?

elephant-tight-ropeThere is nothing like a real-life example to bring this concept to life…so here you go. I was just working on a retirement income plan for a couple who recently retired. At Surevest, we use financial planning software to help analyze various scenarios. We entered this couple’s planned spending, guaranteed income sources (Social Security and pensions), investible assets, and age to which we want their money to last. We found that the portfolio we recommended had an 87% probability of supporting their planned lifestyle through the rest of their lives. The projected average annual returns for this portfolio were 6.7% with a standard deviation of 10.8%. Standard Deviation is a measure of volatility. You don’t need to understand the details of how it is measured, just that the lower the standard deviation, the better (more consistent returns).

The question is: Would a different portfolio give us a better chance of success? Unfortunately, the reality of investing is higher returns typically come with higher volatility. We looked at a portfolio that we expect to earn substantially more, 8.8% per year instead of 6.7%. You would think that the higher return would result in a higher probability of success. However, the more aggressive portfolio has an expected volatility of 18.3% and the probability of supporting this client’s lifestyle for the rest of their lives actually dropped from 87% to 76%.

A range of projected returns, volatility, and probabilities of success follow in the table below. Naturally, this is for a specific couple based on their personal situation, but the concept is universal.
 

 

Return              Volatility
(Std deviation)
Probability of
Success
5.5% None 100%
6.7% 10.8% 87%
7.6% 14.7% 79%
8.8% 18.3% 76%

 

 

Notice that if you could get the same return every year (no volatility), your required returns would be much lower. Sadly, there are no investments with zero risk or volatility that are currently yielding 5.5% (at least that we know about).

As always, we invite you to email back with thoughts, questions, and comments. Have a great week.

Disclosure: Returns are projected and do not represent any specific investment. Numbers are for discussion purposes only. Past performance is never a guarantee of future returns.

Jeremy A. Kisner, CFP®, CPWA® is a Senior Wealth Advisor at Surevest Wealth Management and author of book: A Good Financial Adviser Will Tell You.
Weekly Insight: Why Volatility Matters was published: by
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