Risk vs. Volatility

Paul Hancock, CFP®    August 21, 2015

As an avid reader and follower of global financial markets, a day rarely 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 portfolio management ability. 

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.

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).

Source: Kwanti and Morningstar

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!

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.

DISCLOSURES

INDEX DESCRIPTIONS

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not reflect fees or expenses.

The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. As of June 2009 the MSCI ACWI consisted of 45 country indices comprising 23 developed and 22 emerging market country indices.

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. This world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. An investor cannot invest directly in an index.

The MSCI® EAFE (Europe, Australia, Far East) Net Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indexes, representing the developed markets outside of North America.

The MSCI Emerging Markets Index SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of June 2007, the MSCI Emerging Markets Index consisted of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

The Dow Jones Industrial Average Index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

The Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indexes that are calculated and reported on a regular basis.

DISCLOSURES

Past performance is no guarantee of future results. Diversification does not assure profit or protect against a loss in a declining market. While we have gathered this information from sources believe to be reliable, we cannot guarantee the accuracy of the information provided. The views, opinions, and forecasts expressed in this commentary are as of the date indicated, are subject to change at any time, are not a guarantee of future results, do not represent or offer of any particular security, strategy, or investment and and should not be considered investment advice. Investors should consider the investment objectives, risks, and expenses of a mutual fund or exchanged traded fund carefully before investing. Furthermore, the investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals.

International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Small and mid-cap stocks carry greater risks than investments in larger, more established companies. Fixed-income securities are subject to interest-rate risk. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. There are several risks associated with alternative or non-traditional investments above and beyond the typical risks associated with traditional investments including higher fees, more complex/less transparent investment strategies, less liquid investments and potentially less tax-friendly. Some strategies may disappoint in strong up markets and may not diversify risk in extreme down markets.

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