Risk vs. Volatility

Posted by hancockp
Categories: Markets Stock Market Investing Bonds Risk Volatility s&P 500

August 21, 2015

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As an avid reader and follower of global financial markets, it’s very rare a day goes by that I don’t observe what transpires in markets. I am fascinated by the ebbs and flows of data, information, economies and markets. Learning new ideas challenges my mind and hopefully improves my ability to manage portfolios.

One thing I have learned over the years is that there is a lot of noise in financial markets. It’s this noise that can easily throw investors off a long-term financial plan. Case in point is what happened today in global financial markets. The lead story on Bloomberg.com tonight reads:

“Turbulence in financial markets gathered momentum amid intensifying concern over slowing global growth, pushing the Dow Jones Industrial Average into a correction and giving other stock gauges their worse losses since 2011.”

“The S&P 500 dropped 3.2 percent, the most since November 2011, to below 2,000. The index is down more than 7 percent from a record after sinking below a trading range that has supported it for most of the year. The Dow Jones Industrial Average fell more than 500 points, as is down 10 percent from its record high in May.”

“More than $3.3 trillion has been erased from the value of global equities.”

A common mistake I see investors make is confusing risk with volatility.

Volatility in financial markets are unpredictable movements, both large and small, in the value of an asset class such as stocks.

Risk can be defined as a permanent loss of capital.

A common statistic used to explain volatility is standard deviation. All things being equal, a higher standard deviation in an asset class will cause higher volatility. Let’s look at the difference between the stock market and bond market over the past 10 years.

*Stocks represented by the MSCI All Cap World Index. Bonds represented by the Barclays Aggregate Bond Index. Data per Morningstar from 1/1/2004 – 12/31/2014.

It’s obvious from this chart that a higher standard deviation (16%) from stocks caused larger amounts of volatility. During the 2007/2008 global financial crisis, the global stock market declined 58.4%. This decline was temporary, but long in duration lasting 495 days (see the red section in the chart below). If an investor stayed the course and remained invested, that 58.4% temporary loss recovered in 1,530 days (in green below).

On the other hand, bonds with a smaller standard deviation (3.3%) exhibited less volatility with a maximum loss of only -5.1%. It’s hard to even see the red and green sections (end of 2008) in the chart below!

Source: Kwanti and Morningstar

Yet even with a large drawdown, stocks still outperformed bonds over this time period by a total of 43%. Over the very long run stocks have outperformed bonds. According to Credit Suisse, since 1900, stocks have returned 8.2% annually while bonds have returned 4.9% annually. In dollar terms, an investment of $100 in stocks in 1900 grew to $1,244,000 at the end of 2014 compared to only $27,995 in bonds!

The mistake many investors make is turning volatility into risk (permanent loss of capital) by selling stocks amidst a large drawdown such as we saw in 2007/2008. It can be very tempting to give up on stocks during large market declines. It’s human nature to react to negative news and returns. However, it’s in these times that investors earn their returns. A better reaction to a large decline in stocks is to rebalance and buy stocks while their down. As the famous Warren Buffett once said,

“Be fearful when others are greedy and greedy when others are fearful!”

References

Bloomberg.com – “Stocks Fall Most in 4 Years as China Dread Sinks Global Markets” 8/20/2015.

Credit Suisse Global Investment Returns Yearbook 2015. Available online at credit-suisse.com.

For disclosures and index definitions please click here.

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