Monday, February 8, 2021

Volatility and risk: Are they the same and why does it matter?

HANYS Benefit Services does not believe there is a single definition or statistic that appropriately defines risk for investors, especially when it comes to the nuances of investing for retirement. Instead, we focus on both the art and the science of evaluating risk, and how both approaches can help investors make informed decisions. Statistical measures (the science) primarily focus on an investment’s historical price movement, which can shed light on the predictability, or lack thereof, of an investment’s returns. Understanding one’s own circumstances (the art) can be a great complement to the science in deciding what risks an investor should take on as they prepare for retirement.

What is volatility?

A popular interpretation of risk is a statistical measure called standard deviation, which measures how wide an investment moves around its average price; or said differently, the dispersion of its returns. Lower standard deviation percentages indicate that the majority of the returns in a data set are close to the average, while a high standard deviation means that the returns are more spread out from the average. Standard deviation is commonly referred to as volatility, and many view it as a reliable measure of risk since it can help gauge an investment’s return predictability.

The table to the right provides a range of return and volatility measures for asset classes commonly seen in retirement plans among mutual funds and index funds. As an example and for perspective, if a mutual fund’s average annualized return has been 7% with annualized volatility of 12%, then the majority of the fund’s annual returns have fallen between -5% and +19% (plus or minus 12% from the average). Over the long term, asset classes with higher volatility have generally outperformed those with lower volatility, as investors can be compensated for the higher risk they are undertaking with such investments.

As the chart below indicates, volatility and drawdowns come with investing in the stock market and it is a part of investing for retirement. Since 1968, corrections (declines of 10% or more) and bear markets (declines of 20% or more) in the S&P 500 have occurred every 2.47 and 7.42 years.

Political and economic events, natural disasters and pandemics have all triggered dramatic short-term moves in the stock market. Short-term, emotional reactions to such occurrences can lead investors to jump in and out of the market, which is a very difficult strategy to successfully execute. However, remaining invested and dollar cost averaging have consistently proven to be successful over the long-term. Dollar-cost averaging refers to the practice of dividing an investment into multiple smaller investments of equal amounts, spaced out at regular intervals. The goal is to reduce the overall impact of volatility on a portfolio, as asset prices will vary each time the periodic investments are made. As a result, the investment is not as highly subject to volatility. Investing throughout the duration of market pullbacks, corrections and bear markets can enhance long-term returns as investments can be made at lower prices.

Does volatility equal risk?

Volatility is an insightful measure, but it should not be used in isolation to evaluate an investment’s risk. While volatility can be derived from very large data sets, it focuses on past returns and does not shed light on the investor’s time horizon or risk tolerance.

There are long-term investors of 10, 20 or 30 years or more who can withstand higher levels of volatility and drawdowns. Their longer time horizon affords them the time to weather a bumpier ride with their retirement portfolios in that they don’t need the funds in the near-term and can let their entire portfolio grow. From a behavioral standpoint (risk tolerance), there are long-term investors who are emotionally unaffected by volatility and will stick to an investment plan regardless of how bumpy a ride it is. For these types of investors, volatility is not necessarily a risk but an opportunity, as their main consideration is the long-term annualized rate of return for their retirement funds to grow over time with higher volatility investments. Their risk could actually be investing too conservatively in low volatility investments and not hitting their long-term return targets or retirement goals.

On the other hand, there are investors for whom volatility is a very appropriate measure of risk. This includes long-term investors who are behaviorally affected by volatility. Even though they are trying to save for their long-term goals, they end up making investment decisions based on short-term price volatility, market news or other short-term developments. In an ideal world, long-term investors should not act in this manner; however, certain investors aren’t able to stay rational and can risk selling at market troughs. This type of investor should treat volatility as a risk since more volatility can lead to poor investment decisions and outcomes.

Volatility is also a primary risk for investors with a short time horizon and liquidity needs, such as those nearing or in retirement. As volatility increases, so too does the potential for forced sales that can lock in losses. Investors that fall into these categories should use lower volatility investments in portfolio construction to help smooth out their return streams and allow for the compounding of returns over time, limiting poorly timed exit decisions and realized investment losses.

Risk will be perceived differently from one investor to the next, and hence, portfolio design and risk mitigation should be customized to each individual based on their time horizon and tolerance for drawdowns. Some investors may embrace volatility as a means to hit their long-term goals, while others will try to avoid it based on their shorter time horizon or a low tolerance for volatility. While drawdowns can be difficult to endure, it is important to remember that downside volatility comes with investing in the stock market and in preparing for retirement, and can actually provide compelling entry points that can enhance long-term returns.

If you have any questions or would like to begin talking to a retirement plan advisor, please get in touch by email or by calling (800) 388-1963.

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