By Adam Harding
Learn more about Adam on NerdWallet’s Ask an Advisor.
Life is full of risks and rewards. You hand your iPad to a crying child hoping that a video calms him down: reward. Instead, he throws the iPad across the room like a Frisbee: risk.
Such risks and rewards are, for the most part, clear and measurable. But that’s not always true when it comes to investing.
Investment professionals commonly communicate risk in markets, portfolios and investments through the use of terms such as volatility, variance, and standard deviation. Each of these refers to how the returns of a market, portfolio or investment have varied from the historical average.
Actual risks need to be identified in each situation and personalized to what the investor cares about. When investing, I might care about not losing money, but I also want to meet my goals. Volatility is the cost of potentially higher returns, and there are specific risks that come with volatility. Some of those risks follow below.
Winning by not losing
Higher highs and lower lows lead to greater volatility. Consider what kind of high an investment must have to offset a previous low: A 5% loss requires a subsequent 5.3% gain to break even; a 15% loss requires a 17.7% gain; a 30% loss requires a 42.9% gain; and a 50% loss requires a 100% gain.
Because the return needed to break even steepens as losses increase, you should emphasize capital preservation. An uphill climb can severely impair your ability to compound returns, which is one of the key components to building significant wealth.
The effect of cash flows
In the real world, investments are made so they can be sold later to achieve a goal. The example above doesn’t account for whether investors are still making those investments (contributing) or selling them (withdrawing). The timing of contributions and withdrawals, along with the underlying volatility of an asset, can have a substantial effect on the end value of your portfolio.
As a general rule, when you’re contributing regularly to a portfolio or investment, you can accept some volatility (see: dollar-cost averaging). When distributions are being made, the opposite is generally true.
In retirement, an investor may require a fixed withdrawal each month for expenses, regardless of the performance of the underlying portfolio. If the dollar amount of the withdrawal is the same, the rate of depletion of the portfolio decreases when performance is good and increases when it’s not so good. Simply put, if a portfolio declines by 50% and the withdrawal amount remains the same, then the distribution rate effectively doubles.
This is why investors nearing retirement typically need to be more judicious about managing volatility, while younger investors with longer time horizons can accept more risk.
Financial planning tip: By limiting financial commitments in retirement, such as mortgages and car payments, investors can maintain a flexible withdrawal plan that adjusts with upside and downside volatility. During the 2008-09 market downturn, the ability to keep funds invested, rather than being forced to withdraw at the bottom of the market, would have allowed an investor to participate in the bull market of the past six years.
Consider the most extreme example outlined in the “Winning by not losing” section: If an investment loses 50% in its first year, it will take a 100% return the following year just to get back to the initial value of the investment. Conversely, if there is a 100% gain in the first year, a 50% loss the following year will erode the entire gain.
When considering this investment, there are two ways to analyze and assess performance.
Arithmetic and geometric averages
The arithmetic average is the simple mean return of the investment over a given time. In this case:
Without recognizing the order of returns and the effect of compounding, one might think this investment averages a 25% return and is a home run. However, as we know from the example above, the ending value is actually zero. So shouldn’t returns be zero?
This is where the geometric average comes into play.
The difference between the arithmetic and geometric averages is called the variance drain. As the variation of returns gets larger, the inaccuracies among these average returns become more pronounced. In other words, when investments, markets, or portfolios swing violently, decreased returns are more common.
Where to go from here?
The above examples illustrate why advisors spend time and resources focusing on volatility. The most important step to knowing how you should feel about investment risk is to take an account of your financial assets and then assign goals to those assets. With those goals in mind and with the help of a financial advisor, you can set a strategy that’s right for you.