As one of the top three retirement killers, it consistently surprises me how widely misunderstood and underestimated the impact of volatility is. The lack of understanding probably stems in some way from the issue that the people managing the money talk about volatility in terms like; standard deviations and return dispersion, and the people who are genuinely impacted by it have no real understanding of what these terms mean.
In the below, I will be focussing on the impact of volatility on the everyday investor. Said another way, the impact of someone’s financial worth fluctuating up and down on a daily basis.
Here are my 7 insights on volatility:
1. Average Returns
First things first, in capital volatile markets, average returns do not exist.
When determining whether to make an investment we will need to make some assumptions on returns. In most forecasting models we must pick linear return assumptions that are chosen based on what we might think is a suitable long-term rate of return expectation (not guarantee!). The reason being that we simply cannot predict volatility with any level of accuracy.
The lower the volatility, the closer the average return will be to the actual (annualised) return.
We are told from an early age in investing that liquidity is good. Well I am here to tell you that it can be very bad. It is no coincidence that the places that people often make the most money are generally the least liquid, the family home and superannuation.
The flip side of the coin of liquidity is volatility, think about it as the evil twin. You don’t get one without the other. Investments with no formal secondary market (e.g. annuities, term deposits) experience far less volatility than those with popular secondary markets (e.g. listed shares). If you increase liquidity, you increase volatility.
3. Bad Behaviour
Humans are inherently bad at making their own investment decisions. The reason that investment professionals exist is not necessarily because they know all about the investments, it’s because it is easier to remove emotion from an investment decision when it is not your money.
Investors will commonly sell an asset that was made with a long-term investment timeframe simply because it has underperformed in the short term. Just think about anyone who sold CBA shares at some point during the GFC. Short term market shocks are not necessarily a softening of economic fundamentals.
When volatility is increased, bad investor behaviour becomes rife.
4. Bad Language
Volatility causes investors to use bad language, examples are:
- My super is doing 10% right now
- I made 15% last year
Firstly, unrealised gains are just that, unrealised. Until you take the money off the table, you have “made” nothing. The rises and falls in the apparent value of the investment are meaningless as they can reverse themselves at the drop of a hat.
Income (rent, dividends etc.) is real as it turns to cash in your bank account. Volatility comes in the form of capital growth/loss and is not real until it is ‘real’ised.
5. Psychological Damage
Humans are emotional. We make emotional decisions. We feel loss and we feel grief. The impact on a 70-year-old opening up their share trading account to see a 10% drop in their share portfolio can be enormous. The anxiety and stress it can cause to someone who may rely on those investments to live cannot be marginalised. The more volatility in a portfolio, the more stress and the greater chance for psychological damage.
6. Money Flow
This is about the speed at which money can flow in and out of an investment. Something with low frictional costs of entry will experience (all else equal) greater volatility than those that don’t.
Property for example, has stamp duty, legal fees, agency fees and so on, often slowing down the rate at which people trade it. Stocks on the other hand have evolved into a world where buy/sell spreads are often zero and low-cost online share trading platforms continue to speed up trading.
7. Capital Consumption
Often referred to as ‘sequencing risk’, the order of return sequence can be the deciding factor as to how long someone’s money lasts. It is essentially the difference between the average return and the annualised (actual) return.
With the length of retirement time frames due to the increase in life expectancy, we are only getting more and more exposed to this phenomenon. Sequence does not matter to a portfolio receiving no contributions or no withdrawals. Unfortunately for us, most people are always either contributing, or drawing from, their super. Making sequencing vitally important.
Generally speaking, the greater the volatility, the faster your capital is consumed. Consider the retiree with $1m in super who spends $70k pa. In a year where his portfolio has dropped by 20%, he/she would have “consumed” $270k worth of capital in one year. To recover that the next year, after accounting for the $70k annual spend, that investor would need a 50% annual return to get back to square one.
As technology continues to speed up markets and we keep finding new ways to fractionalise ownership of larger assets, investors will need to become acutely aware of how to handle volatility. From what I can see, it doesn’t look like the money managers of the world are going to do it for them.