During my college days, a couple of friends and I spent time at Cedar Point, an amusement park in Sandusky, Ohio, considered the “Roller Coaster Capital of the World”. One of my friends didn’t want to get on a ride called Top Thrill Dragster — an impressive behemoth of twisted metal that hits speeds of more than 120 MPH and thrusts riders 420 feet high on rails. It is exhilarating, frightening, and volatile all at the same time. Although there was an initial hesitation at the beginning, the friend who didn’t want to ride was all smiles at the end of the run.
What does a roller coaster have to do with investing?
The story about my friend and the roller coaster got me thinking about volatility as it relates to investing. Financial markets are similar to coasters, albeit somewhat opposite. While riding the rollercoaster, you can see the track ahead and you know that after tremendous fear will come tremendous relief as you exit the experience unscathed.
However, as one rides the waves of the market, there is no track ahead to indicate where you are headed or to help you anticipate the ups and downs of markets, what we call volatility. You also have no guarantee that you will have all your money intact at the end of the ride. Indeed, the market’s movements can be fast, and emotions can turn quite quickly.
Why are we talking about market volatility and what is it anyway?
Volatility is simply an experience of movement, both up and down. Scientifically, standard deviation is used as a measured proxy of volatility. In markets, the higher the standard deviation, the more variable the returns of an asset, i.e. the more volatile the ride when invested in that asset. The measurement of volatility is a tool to help assess the riskiness of an asset.
Typically, we talk about the waves of the market in terms of volatility. If I only count price movements of 10% or more, this is what the S&P 500 Index has done since November 2017*:
- S&P 500 rose nearly 12%
- Only to fall just shy of 11%
- Followed by a rise of a little more than 13%
- Then fell again by almost 20%
- Only then to see a rise of more than 30% since the lows of December 2018
This does not even include the multiple movements between 5% and 10% … whew! It’s like a roller coaster ride, right?
Is volatility normal?
After experiencing so much volatility in two years, I began to ask myself, is this normal? Looking at data from Factset and Standard & Poor’s, since 1980, the S&P 500 averages an intra-year decline of nearly 14%. This means the S&P 500 will experience, on average, a 14% decline during a calendar year period. (Note: the majority of the data points fall between a 10%-20% decline.)
This seems to suggest that the market, or at least the stock market, is inherently volatile! Fourteen percent is a big drop, no matter how you look at it. To look at it in another way: It is your portfolio falling from $1 million to $860,000.
What follows when a market reaches its peak is a drop back to reality and this descent can be heart-stopping. The volatile experience of a roller coaster drop seems like a walk in the park when staring at a significant drop in your life savings — especially when you are retired and no longer adding to your portfolio.
Is volatility necessary?
While I asked myself if volatility is normal, perhaps the better question to ask is if volatility is necessary.
Unless you are invested in a security that offers a guaranteed rate of return, you can expect volatility. The difference is all about the level of volatility you choose to experience. You might be someone perfectly content with the roller-coaster like moves involving high risks and big payoffs. However, if you are like most people, you probably fall on the spectrum of wanting some calm and comfort interspersed with the volatility and risk taking.
There are investments, other than stock market investments, that can be used to reduce overall volatility, while still adding value to the portfolio. Volatility in a portfolio is not a mandate or requirement. Instead volatility should be seen as a measure of risk-taking that should be compared against, not only the return expected, but also the return experienced.
What do I do with the volatility I experience?
As with the coaster, volatile drops are most likely to occur when extreme movements are experienced. This is when you need to be vigilant because during these periods of great movements there is opportunity to make reactive, and, possibly, poor decisions.
Once you strap into your seat on a coaster, you are there until the end, no matter how drastic the ups and downs. However, with the markets, you decide when you’ve reached your limit. You can get off the ride whenever you choose.
Anticipate the ride’s potential highs and lows as you consider your portfolio allocation. How much of a drop is comfortable for you? Do you thrive on the excitement from the rising and falling? Or, would you prefer to lower that stock market allocation in favor of less stress?
How volatile is my portfolio?
We devote a lot of hours researching investment strategies and current market conditions at Briaud Financial Advisors. We are always looking for ways to deliver the appropriate balance of risk and return— In particular, our focus is on minimizing the volatility experienced by our clients.
If we can help you navigate volatility in your portfolio, you may reach us here.
*Information regarding the S&P 500 was taken from data provided by YCharts. Please note this data of price movement was of the S&P 500 Index (^SPX) and does not include dividend income.
Post written by Matthew McKay, CFP®. He joined our team in 2017 and earned his CERTIFIED FINANCIAL PLANNERTM certification from North Carolina State University. Learn more about Matthew here.