Volatility Trap

Avoiding the Volatility Trap

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With recent stock market turmoil, there have been plenty of renewed questions from nervous investors about the concept of investing risk.  Are stocks really a good idea?  Is the volatility worth it?  Should I get out now while I still can?

Astute stock market bears point out that there have been many rolling periods where the inflation-adjusted stock market lost money for more than a decade.  Recently, a 100% stock market investor starting in 2000 experienced 13 years of negative real returns before finally breaking even.   Stocks absolutely do work out well in the long run, but if you’re not prepared to wait them out for at least a decade without questioning your plan and switching course, you may be in for a tough emotional ride.  And remember, if you switch portfolios all the time you generally lose money.

Cooler heads are understandably fond of quoting the long term average returns of the stock market.  Since the S&P500 averaged an 8.5% inflation-adjusted return since 1900, there are many years of history to prove that if you are patient and invest for the long run, it will all work out for the best.  “High risk, high return” is a common mantra, meaning that the extra volatility carries a proportionally higher reward.

The idea that returns are linearly proportional to risk often leads to well-reasoned (but shaky, as I will explain) decisions about asset allocation.  Would someone trade 1% a year for significantly more dependable returns?  Judging by the popularity of hedge funds with expenses in that range that seems like a reasonable assumption, and retirees looking for consistency over maximum growth might find that particularly appealing.  Would they trade 2-3% a year?  Maybe not.  That’s a lot of money to give up over time.  So people study the averages and make the best decision they can.

But what if I told you that the risk adjusted return for stocks is a lot less than you might think?  While the S&P500 averaged 8.5% a year after inflation since 1900, the compound annual growth rate (sometimes also called the “geometric mean” or simply abbreviated “CAGR”) that you would have actually experienced in tangible dollars if you were fully invested over that timeframe is only 6.6%.  That’s a big difference!  The difference is a result of something called “volatility drag”.  In layman’s terms, the more volatile the investment, the more your actual returns will trail the average.  Math lovers can read about the details here and even play with those S&P numbers for yourself.  If you take away only one thing, remember this:

Compound annual growth rates are always more valuable than averages when discussing portfolio returns

It’s the difference between real-life cash and fake monopoly money.  In the investing world, you always make less than the average!  That’s fundamentally why all of the tools here quote CAGRs rather than averages.

Let’s compare two portfolios to demonstrate how this might affect the decision making process: The Total US Stock Market vs. the Permanent Portfolio.

Total US Stock Market Returns by Period Pixel Chart

Permanent Portfolio Real Returns by Period Pixel Chart

One can very quickly see in the Pixel charts the difference in overall volatility between the two portfolios.  The stock market has many breathtaking highs and protracted painful lows, while the Permanent Portfolio is a sea of consistent 3-6% real returns.  Looking at the average returns, one might reasonably conclude that the volatility of the stock market was a small price to pay for an additional 2.4% per year.  Adjusted for the effect of volatility, however, the difference in CAGR was only 1% a year.  For many people, 1% might be a very reasonable tradeoff for 60% less volatility and a much more pleasant and predictable investing experience.

Still not satisfied?  Let’s look at another option: the Swensen Portfolio.

Swensen Returns by Period Pixel Chart

A reasonable long-term investor might look at a portfolio with 50% bonds and real estate and inferior average returns and conclude that adding more stocks (and volatility) is a good idea.  However, an investor would have actually made slightly MORE money (measured by the more accurate CAGR) with the Swensen portfolio than with the total stock market over the long run, with shorter and less severe drawdowns along the way.  There’s clearly more to the story than average returns, and volatility plays a larger role than many people realize.  It hurts you not only in your anxiety levels but also in your ultimate account balance.

So what does this all have to do with nervous stock investors?  Should they sell and switch to the Permanent Portfolio or the Swensen Portfolio?  Absolutely not!  The point of the exercise is not to feed fear or to promote any specific alternative, but to open your eyes to a few of the assumptions that may have backed you into the emotional corner you find yourself today.  If you feel the urge to panic, take that as a sign that your tolerance for volatility is lower than you might have previously believed.  People sure love volatility when their account balances shoot up, but when it swings the other way they finally see the whole picture and it often isn’t pretty.

Volatility sucks.  Own it.  Really let the pain and frustration soak in.  Maybe even keep a journal about it so you remember it later.  Now don’t act on your feelings right away, but don’t ignore them either.  As you learn more about yourself and eventually explore alternative portfolio options with a more relaxed mindset, be sure you select one that meets not only your financial goals but also your emotional needs.  And definitely don’t be swayed by deceptive average returns that ignore the mathematical effect of volatility, as the relative payoff for your pain above and beyond more palatable alternatives may not be as substantial as advertised — if it even exists at all.

Don’t be freaked out about the stock market.  But also be realistic about its history.  Find a middle ground with a diverse portfolio you can truly stick with through ups and downs, and you’ll most likely be a lot happier and wealthier in the long run.