Dealing with Investment Volatility

By Jim Terwilliger

Continued from last issue

In a previous column, we explored the concepts of volatility and sequence-of-returns as they relate to investing.

First, let’s consider volatility. Volatility is the investor’s enemy. But it is also the investor’s friend. How can it be both?

As discussed previously, volatility is the up and down movement of the stock market, short and long term. This “bumpiness” reduces the annualized (or effective) return.

For example, for the 15-year period ending Dec. 31 2018, a broadly-diversified stock index portfolio yielded an average return of 9.6% per year. But the annualized return over this same period was 7.8% — almost 2% lower. It is the annualized return that determines investment gain, money in your pocket. The bumpier the ride, the lower the annualized return.

What about this “friend” business? It’s all about the relationship between market risk (volatility) and return. If stocks were not volatile, they would not offer appreciation potential. It is their volatility that makes them attractive as a vehicle to generate wealth. No risk, no reward.

Sequence-of-returns is similar. It can be the investor’s friend or enemy.

Over an investment time period, early good returns followed by poor returns yields favorable results during a portfolio’s distribution phase, say, during retirement. But this same sequence yields a poorer outcome when accumulating money, say, during working years.

Conversely, early poor returns followed by good returns yields favorable results when accumulating. But this same sequence yields a poorer outcome during the distribution phase. This is why folks who retire just as the market is suffering a prolonged decline often need to find part-time work or reduce spending in order to guard against ultimately running out of money.

Sequence-of-returns has no impact on a lump sum investment with no cash flows in or out.

We can’t control market volatility or sequence-of-returns. Our recourse is to employ tools we can control to moderate volatility and sequence-of-returns within our portfolios. One powerful tool is diversification. Diversification is necessary because we cannot consistently predict what the market is going to do and when it will do it. If we could, diversification would not be necessary. But if we could predict, everyone else could as well, and market rewards would vanish.

• Macro Diversification. The first diversification decision is to choose the overall ratio between stock holdings and bond/cash holdings. This ratio for a given investor depends on several factors including goals, time horizon and risk tolerance.

The higher the ratio, the higher the risk/volatility and the higher the expected portfolio return. The bond/cash portion serves to dampen the gyrations of the portfolio and generally is not tasked to contribute to returns other than through interest/dividend income.

• Micro Diversification. Within the stock portion of a portfolio, it is advisable to allocate among equity asset classes such as small-, mid- and large-company domestic stocks; foreign-developed and emerging-market stocks; and global real estate. Similarly, within fixed income, it is advisable to allocate between domestic and foreign bonds. The allocation ratios within each portion depend largely on investor preference but should be relatively stable once established.

– Volatility — Broad diversification, particularly within the stock portion, can reduce portfolio volatility and produce a smoother pattern of returns over time compared to a single stock asset class such as the S&P 500 index. For example, for the 10-year period ending Dec. 31, 2009, a broadly-diversified all-stock portfolio exhibited a 7.5% annualized return vs. a negative 1% annualized return for the S&P 500. For the next 9.5 years through June 30, 2019, the same diversified portfolio exhibited a 9.6% annualized return vs. a 13.1% annualized return for the S&P 500. I’ll take the smoother, steadier ride any day.

– Sequence-of-Returns — A recently-published study looked at the performance of two all-stock portfolios (diversified vs. S&P 500) in a distribution mode over two past 10-year periods — 1990 through 1999 (sequence-of-returns favorable for distribution portfolios), and 2000 through 2009 (sequence-of-returns unfavorable for distribution portfolios). Each portfolio was initially funded with $1 million, 4.5% was withdrawn the first year, and distributions were increased by inflation in each of the following nine years.

The diversified portfolio ended with $1.3 million at the end of both 10-year periods. The S&P 500 portfolio ended with $3.5 million at the end of 1999 and with $0.4 million at the end of 2009. Again, I’ll take the smoother, steadier approach offered through diversification.

• “Secret Sauce.” Actually, there is no secret. Diversification works because it populates a portfolio with components that do not move in concert with each other. The net result is decreased portfolio volatility and improved portfolio returns. It is said that diversification is the only free lunch in investing. It sure is.

James Terwilliger, CFP®, is senior vice president, senior planning adviser at CNB Wealth Management, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at jterwilliger@cnbank.com.