Below is an article on risk and volatility and I think it is a great reminder for our clients that risk and volatility need to be thought of as separate items. Volatility is how much the your stock or the markets went down last week or last quarter. Risk the chance you have of losing money that you will never recover. It is permanent loss of capital. An example of permanent loss of capital would be if you owned Citibank in 2007, today, 6 years later, you have lost 90% of your of investment. That is a an example of risk you want to avoid.
Jon Houk, CFP®
By: BRUCE BRUGLER
Investors and advisers typically think of risk as one thing: volatility. When you look at modern portfolio theory, it asks what return am I going to get per unit of risk? Increasingly, however, we believe that short-term risk and volatility don’t matter as much as the permanent loss of capital.
To illustrate this we looked at what would have happened over the past 50 years to a hypothetical investor with terrible timing. We looked at the nine times in the past 50 years when equity markets crashed, including the 2008 downturn.
Then we asked: If someone invested at the peak of these markets right before they tanked, left their portfolio untouched for five years and came back, how often would that portfolio have actually made money? The answer is every single time—as long the investor stayed invested for the period.
Once investors accept that volatility isn’t the enemy, advisers should focus on two things to help them stay comfortable in the market. First, make sure clients have enough liquidity to meet their needs through downturns, so they don’t have to sell when the market bottoms. Second, make sure they’re comfortable with their portfolio’s assets and allocations. That way, clients won’t be tempted to sell in a panic if the market turns down.
Investors and advisers should also make sure that portfolios are truly diversified. Looking at the asset-class breakdown may not tell the whole story. For example, an asset class called hedge funds may actually be highly correlated to equity markets and not all that different from other investments.
Finally, it is important to evaluate the real level of risk tied to any particular investment. Don’t rely solely on asset-class nomenclature or historical characteristics of investments to do this, but rather skeptically evaluate each type of investment.
The real risk in long-term investing isn’t volatility in the short term—it’s not staying invested despite the volatility that happens in the short term.
A version of this article appeared June 10, 2013, on page R8 in the U.S. edition of The Wall Street Journal, with the headline: Volatility Isn’t the Enemy.