Volatility is your Enemy
Volatility is one of the biggest enemies of superior
investment performance, but is the one most ignored by the
average investor. Actually, it's not the volatility itself,
it's our reaction to it. Without volatility, there is no
real opportunity for above average profits.
We know that after suffering through the
2000
– 2002 bear market, that it doesn’t
matter how much money your brain is telling you a system
will make, if the fund values have wild swings up and down,
your gut will take you out before your brain will get you
back in. The drawdowns of 50 to 80% we saw in the major
stock market indexes make it very difficult to stay invested over time.
In short, in order for you to make big money in any
investment system, you have to have money invested in it.
And if you are anything like most people, you won’t
have money invested in it for long if it has big drawdowns
in value every time the stock market hiccups.
So, volatility imposes a penalty in that it will tend
to have us get out of the market at the lows, and
conversely overinvested at the highs.
This is one of the key justifications for
diversification. For example, there are a
number of newsletters that invest in Fidelity
Select mutual fund portfolios with only one fund. I’ve
invested in some of these, and they are usually a lot of
fun when the market is going up. But when it goes down, it
can get ugly in a hurry.
The example system that we
discussed yesterday of rotating from one Select mutual fund to the next, has a compounded
annual return of almost 20% over the last 17 years, but it also has
also had a maximum drawdown of over 50% in that time as
well.
Once again, when you see a drawdown like that it is
hard to stay invested.


There's a variety of ways to characterize risk in the
markets, and most of them equate volatility to risk. One
very common one is to simply take the annualized return of
the investment, and divide it by the maximum drawdown seen
on the investment over several years (often seen as
ANN/MDD). Another very common one is the
Sharpe ratio, which basically measures the
excess return (the return you see over a riskless return
like a money market fund) and divides that by the standard
deviation of the monthly returns. This is the one favored
by
Morningstar and Hulbert's Financial
Digest newsletter.
Now, even if you have the stomach for a lot of
volatility, there's another penalty that volatility
imposes on your investments. This is known as volatility
drag. This is best explained by an example. For the 30
years starting in 1966 the S&P averaged 7.8% a year.
Yet if you looked at the actual return if you had
invested 1000 at the beginning of this time period, you
would have ended with %666K. But that's only a compounded
annual return of 6.5%. Where did the money go?
Consider a simpler example. Let's say you invested your
money for 2 years, and it went up 30% the first year, and
then down 30% the next year (the order doesn't matter, you
could have the loss first if you want.) Obviously, that's
and average return of 0%. Yet, if you had 1000 invested,
after the first year you would have $1300. After the second
year, where you lose 30%,
you would have 1300 *
0.70 = $910, or a loss of 9%! That's volatility
drag! The greater the volatility, the greater the
difference between the "average" return and the actual
return.
Take the scenario where you’ve achieved your dream,
you’ve saved up 1 million dollars and plan to live
the next 40 years on it. You decide to invest it in an
S&P 500 index fund, because you know that it
has averaged 7.8 % for the last 40 years.
So let’s take the actual returns on the S&P 500
starting in 1966, with the advantage that we know that it
will average a 7.8 % return over the next 30 years. We will
only withdraw 40k the first year, and then increase that
amount by 3.5 % a year to capture inflation. (so the second
year we withdraw 41.4 k, the second year 42.8K, and so on)
Since we know we are going to average 7.8% a year,
and we are taking out ½ of that, that would seem like the
most conservative of approaches, true?


Surprise, with that conservative financial plan,
instead of lasting 40 years, your money would last
just 21 years! How can that be? It’s the
volatility drag again.
So, as you look at investment vehicles for your hard
earned dollars, look at the volatility of you’re
the returns. To summarize, volatility is your enemy
because it:
1) Creates self doubt, getting us out of the market right
when we should be getting in
2) Volatility drag actually reduces the total returns
that we see.
The usable returns are not the average returns, but the
compounded returns, which are really reduced by
volatility. When you compare your investment options, be
sure you are looking at compounded returns, which by
their nature will have this factored in.
It often happens that funds that are ready to make that big
breakout to the upside will form a base, when they sit
there for a long time doing nothing, and then make their a
big run up. So, adding volitility to the system design not
only helps you stay invested, improves your compounded
returns, but helps provide better returns as well since you
improve the odds of catching a winning trade.
So, where can we best put all this information to work.
Understanding all this, we've worked to reduce volatility
in the systems we publish. When you are looking at your
investment choices, be sure to
get the information
on the maximum drawdown that the investment has
seen. Ask yourself if you could really have held
on to that investment during the time that drawdown
occurred. If not, the you probably need to seek out a
system that will have a lower risk (and most likely a lower
total return. As the old saying goes, you need to adjust
your risk to the point where you can sleep at night.
Note for geeks: If
you’re thinking this sounds like using the Sharpe
ratio (which is basically the return over and above
riskless money market return divided by the standard
deviation of the returns, you’re right. You can learn
all you want about Sharpe here.) However, a couple of
observations:
1) For the measurement period that we use, the standard
monthly or weekly calculations of the Sharpe ratio that are
used are useless. We calculate our metrics using daily
data.
2) Sharpe weights all returns the same, where we weight the
more recent price action more heavily
3) Sharpe uses the same measurement period for both the
return weighting and the volatility measurement.
We’ve found that’s not necessarily optimum.
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