## Quiz!

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

1. -50%
2. No impact.
3. +50%

## How to Use Volatility to Make Money

Investment volatility is the investment’s movements up and down away from its average growth. It is commonly viewed as a negative, but for a disciplined long-term saver, it is typically a positive. A hypothetical example can demonstrate it. Let’s compare 2 portfolios with identical returns, and different volatility:

 Portfolio 1 Portfolio 2 Year 1 0% -50% Year 2 0% 100% Average 0% 0%

If you start with \$100, both portfolios will be worth \$100 after 2 years. Specifically, Portfolio 2 will go through the following values: (Year 1) \$100 – 50% = \$50. (Year 2) \$50 + 100% = \$100. The portfolios have identical average growth, but Portfolio 2 is far more volatile.

Let’s see the final balance if you add \$100 in the beginning of each year:

 Portfolio 1 Portfolio 2 Year 1 (\$100 + 0%) = \$100 (\$100 – 50%) = \$50 Year 2 (\$100 + \$100) + 0% = \$200 (\$50 + \$100) + 100% = \$300

Even though both portfolios have the same average growth, when adding to both portfolios identical amounts each year, the more volatile portfolio ended up 50% higher (\$300 vs. \$200).

How is this possible? The percentage going back up is greater than the original percentage going down. When a portfolio recovers from a 50% decline it goes up 100%. This is because the percentage going up is relative to a lower starting amount. While old money simply recovers, new money that was invested low goes up \$100 – double the -\$50 impact of the decline.

Notes:

1. Some investors lose faith in their portfolio after declines, and hold off on investing (or even sell). If you do that, you can negate the entire benefit of volatility and even hurt your returns.
2. Even with discipline, there is a special case that can lead to a negative effect. The case involves no up period after a down period, for example, only up years followed by only down years. This is not a concern for disciplined lifelong investors, because such a sequence is limited to one cycle or less.

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

1. -50%
2. No impact.

Explanation: See this month’s article for an analysis of this scenario.

Disclosures Including Backtested Performance Data

## Quiz!

If the longest possible decline (peak-to-peak) for ET (Extended-Term Component) were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

1. Less than 3 years
2. 3 years
3. 12 years
4. More than 12 years

Look for the answer below and read this month’s article for a discussion.

## Volatility is not the best Measure of Investment Risk

Volatility is the most common measure of investment risk.  There are a number of reasons:

1. Some investors panic and sell at a low point.  Selling a high-growth high-volatility investment at a low point can negate the entire benefit of the high average growth.
2. Some investors build concentrated portfolios, where volatility involves the risk of a loss that extends beyond a market cycle.
3. When the horizon of the entire investment is shorter than a cycle of a volatile investment, volatility can lead to a permanent loss if it is fully sold at a lower point in the cycle.

What if you are a disciplined investor, saving for retirement (or being in retirement, with limited annual withdrawals), and are able to stick with your plan throughout the cycle?  In such a case, seeking low volatility at the price of lower average returns, can lead to higher overall risk, given the risk of outliving your money – the opposite of what is intended.  If you are going to stick with your plan throughout the cycle, a higher-growth diversified investment is less likely to leave you bankrupt as a result of regular retirement withdrawals.

Another factor is the position in the cycle.  While it is impossible to identify the precise peaks and bottoms of the cycle, there are certain factors that are not typical for peaks:

1. Valuations are lower than usual.  The beginning of the worst declines tend to occur at very high valuations, not low.
2. The investments are in the midst of a deep and long decline.  For example, if the recent peak was 9 years ago, and you are at a 28% decline, your risk level is much lower today.  And, to continue the example, if the total decline is 12 years long, you get a 39% gain in the remaining 3 years.

If the longest possible decline (peak-to-peak) for ET were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

1. Less than 3 years  [The Correct Answer]
2. 3 years
3. 12 years
4. More than 12 years

Explanation:  Since we are over 9 years into the current decline, if 12 years were the longest decline, the remainder would be at most: 3 years.  With the portfolio currently 28% below the 10/31/2007 peak, not only would you recover any decline within 3 years – you would enjoy an addition gain of 39% (to revert the starting point of -28%).  This means that the longest decline to recovery of an investment made today would be substantially less than 3 years.

Disclosures Including Backtested Performance Data

The combination of the 2008 stock market crash and the wave of retirees brought volatility to the spotlight, and many are looking for any way to reduce it. This article questions the idea of sacrificing returns to reduce volatility, and suggests ways to be happy in retirement while investing in a volatile portfolio.

The article is aimed towards retirees who want income for as long as they live. To achieve that, a limited annual withdrawal from the investments is assumed (e.g. 4% of Long-Term Component by QAM, and 3% of Extended-Term Component). With higher withdrawal rates, you take a real chance of outliving your money.

Volatility is the movement of the portfolio price up and down around its average growth. The greater the volatility, the further the returns tend to go below and above the average. A simple way to reduce volatility is to combine multiple investments that don’t all move in the same direction at all times. Ownership of one fast growing company can provide substantial returns, or a total loss. By adding many companies from various industries and countries, you virtually eliminate the risk of total loss.

Even without a total loss, substantial declines can be problematic for retirees. Retirees depend on their investments for immediate income. They cannot decide to stop eating because a 50% decline occurred. A withdrawal of \$1 at a 50% decline costs \$2, resulting in a substantial loss on the withdrawn amount. This leads retirees and financial professionals serving them to try to minimize volatility. It seems logical, at first.

If volatility were not a consideration, retirees could put all of their money in stocks and get nice long-term average returns. In order to reduce the volatility, most retirees put a meaningful portion of their money in less volatile investments such as bonds. This allocation indeed moderates the declines, and can significantly reduce the excess cost of withdrawals during deep declines of stocks.

Volatility Cost

Assume that you are a retiree living on 4% of your stock portfolio Long-Term Component, or 3% of Extended-Term Component. The total effect of declines on the annual withdrawals during the 3 most harmful declines as simulated since 1970 is:

 Cost of Retirement Withdrawals from Stock Portfolios During Severe Declines 4% annually from Long-Term Component 3% annually from Extended-Term Component Decline to New Peak Cost 1 Decline to New Peak Cost 1 4/1973 – 12/1975 2.5% 7/1973 – 12/1976 2.7% 4/2000 – 5/2003 1.4% 1/2000 – 11/2003 4.8% 11/2007 – 6/2013 2 7.3% 11/2007 – 6/2013 2 6.5%

Even severe declines resulted in very small losses to a retiree thanks to limited withdrawals and global stock diversification.

The next table shows the long-term average cost of withdrawals during declines, and impact on the returns:

 Cost of Retirement Withdrawals from Stock Portfolios During Declines Annual Average 1/1970 – 6/2013 Portfolio & Annual Withdrawal Rate Returns Cost 1 Net Returns 3 4% from Long-Term Component 16.4% 0.35% 16.1% 3% from Extended-Term Component 19.2% 0.46% 18.7%

The withdrawals during declines reduced the returns only minimally. The net returns above are the returns achieved with a portfolio that never experienced a decline.

Solutions that reduce the volatility of stock portfolios (only partially), cost far more than the costs above (<0.5%), and result in far lower average returns, erasing the entire financial benefit of volatility reduction. As an example, bonds don’t provide annual returns much higher than 5%-8%.

Happy Retirement with Volatility

So far, we saw that reducing volatility is likely to hurt the retiree’s financial security. Yet, living through the decline periods can be tough psychologically. How can you stay happy while going through deep and prolonged declines?

1. Remember that the impact of severe declines on your limited withdrawals is very small.
2. When investing in a globally diversified stock portfolio, declines don’t sustain. The declines are like pressing a spring very tight – at some point it is released and there is a surge. While the well-publicized concentrated investment – the S&P 500 – had extended downturns, the returns for the globally diversified portfolios were much better in all 10-year periods as simulated since 1970.

 Range of 10-year annualized returns 1/1970-6/2013 Portfolio Worst Average Best S&P 500 -3.4% 10.2% 19.5% Long-Term Component 6.3% 16.4% 28.3% Extended-Term Component 4.4% 19.2% 40.5%

If your average returns in recent years were on the low end of this scale, or even below it, you can be optimistic that your chances are for better than usual returns (no guarantees).

3. Supporting the point above is a simple view of valuations (price/book, or liquidation value) of your portfolio. Typically, after extended periods of poor performance, the valuations of the portfolios become much lower than typical. They reflect the fact that people tend to over-sell investments when there is bad news or uncertainty. Supporting the “over-selling” theory is the fact that deep and long declines don’t start with low valuations – they start with high valuations. So, when valuations are low you can be much more optimistic than usual.
4. The expectation for returns to be meaningfully positive over time is logical. Companies use materials, labor and capital to generate added value. While a number of companies can fail, the whole system of efficient production is likely to stay with us, since people typically want things done for them in the cheapest and most efficient way possible.
5. If you listen to the economic news frequently enough, you are likely to expect every large decline to be “the new normal”, where returns don’t revert back to the typical. This has been predicted many times before, and always turned out to be wrong. In addition, the news typically focuses on concentrated portfolios in just one or a few countries.

1 For example, a year-long 20% decline combined with a 4% withdrawal, costs 1% calculated as: 4% of the remaining 80% = 4 / 80 = 5% = 4% of the peak + 1% penalty for selling during the decline.

Note: Investment taxes (taxes on dividends, capital gains distributions, and capital gains) are not accounted for, as they are dependent on the investor’s tax rate. They are not material enough to change the conclusions of this article.

2 A peak was reached, but the portfolio declined since then. While there are no guarantees, conservative assumptions lead to a small expected additional cost of 0%-2%.

3 Net Returns = Returns – Cost [of withdrawals during declines]

Disclosures Including Backtested Performance Data