With Volatility, Emotions Can Get in the Way

by Steve Cassaday, CFP®, CFS

When we distill out all of the noise in the world of investment advice there remains an essential immutable truth: The presence of volatility in individual investments and portfolios is the reason most people don’t get the investment outcome they would like. Here’s why:

Volatility in the investment lexicon means variance in returns above and below an average. Knowing the average return of an investment tells us little about its volatility, we must also know the range of returns above and below the average. The greater the variances in returns the greater the investment’s volatility.

Volatility encourages attempts at timing and our experience has been that more money is lost attempting to time than any other activity. Many investors believe that they can avoid the negative extremes by attempting to time their investments to avoid the negatives and participate in the positives. When portfolios are less volatile, correct timing decisions, or incorrect ones, don’t really make a difference. Since the range of potential returns are narrow, timing decisions are less important because at any given entry point, the future returns are less likely to be dramatically better or worse than the historical averages. Although less volatile portfolios will underperform from time to time, their lower volatility may make it easier to remain invested for the long term. If you can stay invested when things are scary and not take inordinate risks when things are hopping, the chances of good long term outcomes may be enhanced.

Volatility brings emotion into the equation and investors are more likely to make behavioral mistakes when their portfolios swing wildly. Emotional decisions are rarely correct decisions and being aware of the impact of emotion is an important part of a potentially good long term outcome. Numerous studies have shown that investors regularly buy at market tops (when they feel comfortable) and sell at market bottoms (when they are nervous) which violates the basic axiom of successful investing: Buy low and sell high. Boring portfolios with lower volatility are less likely to cause your blood to heat up and induce emotional reactions. This cannot be stressed enough: the secret to successful investing is not timing or talent, it is temperament. With low volatility your disposition is more likely to be balanced and steady which means you may have a greater willingness to stay invested and think long term.

Volatility is used regularly in sales pitches to investors in an attempt to seduce them into doing things. It works both ways, when an investment is doing well, we feel more comfortable buying in. The positive volatility is used as a device to induce a purchase decision. Conversely, when an investment avoids volatility and is stable and “safe” investors who have previously been burnt are receptive to a pitch that offers a safe harbor. This is especially true today because the memory of 2008 is fresh in everyone’s mind. Unfortunately, both of these approaches have risk, just different kinds. With the former the risk is obvious because of its volatility. With the latter the risk is not that the investment will blow up but rather that it may not produce sufficient returns to support a long lived baby boomer’s retirement.

In today’s interest rate environment, good yields are hard to come by and taking profits to enhance cash flow is an increasingly common scenario. If investors are forced to supplement income through liquidations, a volatile portfolio could mean forced selling during periods of extreme negative fluctuations. Over time this pattern can inflict irrecoverable damage to retiree portfolios forcing reduced withdrawals or worse, depleting portfolios.

Understanding the impact of volatility on investment outcomes is a key component of a potentially favorable investing experience. Although there are no guarantees and risks still exist, broad diversification in a portfolio has the potential to produce pretty good average returns with volatility most investors will be comfortable with. Broadly diversified portfolios should contain all four major asset classes: Stocks and hard assets for potential growth and bonds and cash equivalents for liquidity, income and potential stability.

As seen in the 3/9/2012 issue of Washington Business Journal


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