Risk vs Volatility vs Turbulence
Hello everyone. Hope all is well.
A standard practice utilized by financial advisors is the completion of a risk questionnaire to help determine the proper allocation of assets in a portfolio. The theory is that investors have a comfort zone for risk, and by utilizing tools like psychological assessments, an advisor can help an investor find that comfort zone, make good and committed decisions and produce a portfolio that will produce returns necessary to achieve their financial goals and sleep soundly.
One of our beliefs is that although this is a good practice, it only scratches the surface. In this version of 3 Questions, we will address three different ways to examine this important concept: Risk, volatility, and turbulence.
Question 1: What is risk?
Investopedia defines risk: “Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.”
We could add to this by suggesting that risk should always be measured over a specific timeframe. So, if an investor has a goal of achieving a 7% annualized return over a 5-year timeframe, risk is the chance that won’t happen.
When you complete a risk tolerance questionnaire, you are judging your tolerance over your projected timeframe. Since December 31, 1999, the worst 5-year period for the S&P 500 would have produced a loss of 8.2% in 2008-2009 but the average would have been a return of 8.5% per year and even with all the turmoil resulting from COVID, investors would have seen returns of 10.68% over the past 5-years and based on the 7% goal, equities seem like a relatively low-risk investment.
If we picked the worst period during the past 20+ years, it would have been what was called the “Lost Decade” between December 31, 1999 and December 31, 2011, the worst 5-year return was the same but the S&P 500 averaged 4.9%, thereby short of your 7% target.
Question 2: What is volatility?
So based on definitions, the problem is not risk; it’s volatility.
Investopedia defines volatility: “Volatility represents how large an asset’s prices swing around the mean price. Volatile assets are often considered riskier than less volatile assets because the price is expected to be less predictable.”
Generally, when you look at volatility, you are looking at short-term metrics. A simple way to look at this is how much an investment declines, and this can be determined by looking at what stock market people call a drawdown. “How much has an investment declined during periods of negative performance in the past”. So, if a stock dropped 30% during its worst period over the past five years, we’d say its 5-year max drawdown is 30%.
Compared to 5-year rolling returns, short-term volatility was much more exaggerated. In 2008 – 2009, the S&P 500 dropped 55%, and during COVID, it dropped 34%.
So, let’s say that five years ago (beginning January 1, 2018), you set a goal of a 7% return. On April 26, 2023, your annualized return was 10.06%, so you achieved your goal, but to do so, you experienced a 34% drawdown.
The end result was positive, exceeding your goal by 3% for the 5+ year period. The question is, “How did you handle the volatility when your $1 million portfolio fell by $340,000”? Based on the definition, you were OK with the risk and return, but the volatility was uncomfortable.
Question 3: What is Turbulence?
The third doesn’t really have a financial definition: Turbulence. Think of it as turbulence on an airplane flight to your favourite destination. Most flights experience some degree of turbulence. Most of the time, you ignore it and read your book, watch a movie, or engage in conversation with somebody you just met. Other times, you grip the armrest, like that is going to provide you with some level of safety and white knuckle until things settle down. By the time the flight lands, you’ve achieved your goal of safe arrival at your destination. There was a small degree of risk (1 in 11 million based on an Internet search) but “at flight cruising levels, only about 3% of the atmosphere has light turbulence, about 1% has moderate turbulence, and a few tenths of a percent has severe turbulence at any given time”, says Paul Williams, a professor of atmospheric science at the University of Reading who researches turbulence.
Besides buying a GIC or government bond, you are guaranteed to experience some turbulence in an investment portfolio. COVID threw your best-laid plans into flux, and recovery from COVID and central bank activity has caused many bumps.
Your goal in structuring an investment strategy is to set your longer-term goal based on longer-term risks with the understanding that there will be turbulence that you can tolerate. Jumping from the plane during turbulence is never a good strategy.
Most people don’t have 100% equity portfolios. If you had a 60% equities/40% bonds strategy, which hasn’t been best during the past year because bonds performed poorly, but we’ll use it as a standard benchmark, your drawdown was 12.53%, so more tolerable volatility.
The problem is that people hold a 60/40 portfolio but watch the equity component like they were 100% equities. When you hold equities in a portfolio, it is important to play a strong mental game. Pick a long-term goal and give it time. Focus on high-quality companies with consistent and predictable earnings growth, trading at reasonable prices and diversifying. Don’t let short-term performance excite you during positive markets or depress you during negative periods. Try to be approximately correct with your allocation and choices and not precisely wrong.
Maybe you can’t tolerate equity turbulence, and that’s OK too. You may want to look for more appropriate asset classes, but always understand the concepts so you don’t invest in fear of the unknown.
(Market information source: Ycharts.com)
Until next time,