Volatility is not the best Measure of Investment Risk

Quiz!

If the longest possible decline (peak-to-peak) for a portfolio were 12 years, the portfolio was down 20% for the past 9 years and you were to invest money in it 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 20% decline, your risk level is much lower today.  And, to continue the example, if the total decline is 12 years long, you get a 25% gain in the remaining 3 years.

Quiz Answer:

If the longest possible decline (peak-to-peak) for a portfolio were 12 years, the portfolio was down 20% for the past 9 years and you were to invest money in it 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 the portfolio is 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 below its peak, not only would you recover any decline within 3 years – you would enjoy an addition gain of 25% that reverts the starting point of -20%.  This means that the longest decline to recovery of an investment made today would be less than 3 years.