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 over-invested 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 risk-less 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 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.

Tomorrow’s Installment: The Best Mutual Fund Family for our system

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