In our previous CH Minute, we looked at segregated funds and how they mitigate risk. This week, we focus on the topic of risk, but also look at volatility and how they differ.
What is volatility?
Volatility can be described as the degree to which a stock’s price fluctuates. During volatile periods, the price may swing sharply up and down while less volatile periods see a more smooth and predictable performance. The question we need to ask is how much of this volatility represents a long-term risk in any given investment?
By way of analogy, we might think of a mutual fund as a sailboat sailing across two different bodies of water. When sailing on a lake’s smooth waters the ride is less choppy, this is our less volatile period. Conversely, a more volatile period is like sailing on the ocean where the waves can get much higher and passengers are much more aware of ups and downs experienced by the boat.
The issue, however, is less on the size of the waves, and more on the quality of the boat, and of the crew that operates it. A strong boat manned by a skilled crew is in less danger than one with holes in the hull and an inexperienced crew.
So, what is risk?
Although there are many types of risks to consider, risk can be defined as a permanent loss of capital. In other words, it isn’t the bumpiness of the ride that will harm investors, it is the sinking of their investments to a point where they will not be able to recover.
As advisors, our duty is to gauge a client’s time horizon and tolerance for risk and then create a portfolio suitable for them. Going back to our analogy, we build the boat to your specifications that you will then ride to your financial goal. We know there will be big waves at times, but the trip will rely on the boat and its crew.
A client that is retired and needs income from their investment portfolio might be less interested in the excitement of the markets and more about the safety. Meanwhile, a younger person knows they need to build their wealth. This means making sure they have an investment portfolio that can withstand the winds and waves of market volatility.
When is volatility the same as risk?
If an investor knows they will need “X” amount of money in a short period, a sudden market downturn could do a lot of damage. Safety and low volatility will be needed and is therefore much more important than the return. In this scenario, volatility and risk are the same.
Likewise, a sudden market downturn that causes an investor to sell out of fear leads to a permanent loss of capital. They cannot make back their losses because they have exited the market. Here again, volatility and risk are the same thing.
For us at CH, we encourage clients to stay invested and make sure that the funds they own are solid. In these cases, market downturns are merely paper losses. If they do not sell then they haven’t lost anything, and their portfolio will enjoy the fruits of the market recovery. No one knows how long the storm will last, but we do know that it will end. This is how our clients have continued to prosper even though they have experienced temporary paper losses from time to time.
No one can stop markets from going up and down. The only way to manage volatility, and not let it turn into risk, is through patience. As the old saying goes, stay invested for the long term. We at CH would add “stay invested for the long term in the right funds.” The right mix of funds may vary from client to client, therefore we use multiple funds and strategies. By understanding our client’s tolerance for risk and volatility, how much return they need to make, and how long they have to make it we can build the right kind of portfolio for them.
Most importantly, we emphasize staying invested during downturns. Volatility isn’t necessarily a bad thing. Research shows that missing only the 5 best days in the market in the last three decades would have led to a 33% lower return for an investor. Being out of the market for the 10 best days during this same period would have led to a return being reduced by 49%.
In other words, if you can, stay invested.
This edition of the CH Minute has sought to show the difference between risk and volatility. They are not always the same thing. Dips might be small, like the one we just had in September, or they may be larger, like in March of 2020, but in each case, we have seen our portfolios recover. Therefore we thought this would be a good time to discuss volatility. If you’d like to discuss volatility or risk further, please don’t hesitate to reach out to your advisor.
As always, we welcome any questions or comments.
All the best,
Devin Gorgchuck, Financial Advisor
& Your CH Financial Team