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Does Volatility = Investment Risk?
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Price volatility has been used as a measure of investment risk for some time. If you want to decrease risk, decrease the volatility of your portfolio is the often heard mantra. But is volatility really a good measure of investment risk? A fellow BI chapter volunteer has maintained he believes it is not. What investors consider risk is the possibility of losing money. Price variation is not much of a factor unless you are in the distribution phase of your investing life. In this phase price variation may cause loss of capital as sales are made to finance retirement. Volatility may cause these sales to be made at lower prices.
In the book, Investing at Level 3, James Cloonan, founder of AAII (American Association of Individual Investors), argues that volatility is not a good measure of risk, especially for long-term investors. Daily, monthly or even annual price variation of a portfolio is not much of a concern if your time horizon is 10 or more years. Also, to decrease volatility one usually adds investments that have more price stability but lower portfolio returns. The lowered return rates add a different risk – not being able to meet your investment goals.
Here is my example of how lower returns from decreased volatility increase a different measure of risk. Assume your goal is to retire in 30 years with a retirement fund of one million dollars. Having a lump sum invested at the beginning allows for the most appreciation and least amount of total out of pocket money invested. An often stated mix of stocks and bonds (60/40) averages a return of 7.5% per year. At this average return for 30 years the initial investment would be $114,220 to be worth one million at the end of 30 years. Going with a more volatile all stock investment such as an S&P 500 index fund raises the average annual return to about 10%. At this rate only $57,308 is needed as the initial investment. If one could invest at an average rate of 12.5% for 30 years, the initial investment drops to $29,203. By fixating on reducing volatility one can increase the risk of not meeting investment goals. To counter the risk of unmet goals one would need to put additional money at risk.
Mr. Cloonan mentions investments that he believes can meet the 10% even the 12.5% average return. He also has a different method for dealing with the disbursement phase of your investing life when volatility can be a major factor. That is beyond the scope of this post. Look into the book for more details on both his take on risk and preparing a portfolio for retirement.
Russell Malley
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Does Volatility = Investment Risk?
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