The word of the day is VOLATILITY, and in the investment world, this word can leave a bad taste in your mouth. Is it avoidable? The answer is certainly not. As an advisor, investor, or both, we all know that volatility is a natural aspect of the stock market or any individual investment. We all wish the stock market appreciated in a perfectly straight line, but then again, it would be too easy and it would not really work the way it has for its 100+ year history if that were the case. With a long-term investing horizon in which natural volatility of the market can be handled, we do make the argument that the stock market is the best place to be for general investing or retirement investing if you are investing intentionally and intelligently. A short-term need for regular income or withdrawal of investable assets tells us that a 100% stock market strategy should almost never be in place due to the natural volatility of the market. However, it does not mean that you cannot aim for great returns while attempting to minimize volatility to the best of your ability, and that is one of the many small aspects of our work that we help clients not only understand but attempt to achieve over a long period of time.
In the investment world, we like to have fancy terms, and two additional terms to focus on today are systematic risk and unsystematic risk. Let’s think of these two definitions in a simpler sense: systematic risk is simply the natural risk of the stock market as a whole, and that heavily involves the concept of VOLATILITY. Unsystematic risk involves the risk of investing in only one company, one industry or sector of the economy, one country or geographical area, etc. Long story short, systematic risk is the risk that we essentially cannot do anything about, with understanding that the market does not go up in a perfectly straight line. Unsystematic risk is diversifiable, meaning that with an intelligent or successful strategy, it can be mostly diversified away. As an advising firm that works in the best interest of our clients first, we care about the appropriateness to a particular situation, merit, and long-term track record of a mutual fund or alternative investment. However, that does not mean we chase returns, or necessarily care only about the long-term return of an individual investment. We certainly utilize Dave Ramsey’s general investment strategy of investing in four different types of mutual funds or in more broad terms, four different categories or “sectors” of the stock market as a whole: Growth, Growth & Income, Aggressive Growth, and International. *See the chart... data is from 10+ years ago but overall concept is the furthest thing from being outdated (:
As a company, we are huge Dave Ramsey fans, but we don’t just take his word on this strategy. More so, this strategy aims to minimize that unsystematic risk and the volatility of returns as much as possible. Please don’t let anyone tell you that you should either just invest in the Amazons, Googles, and Facebooks of today or in the smaller companies that could be the next Amazon, Google, or Facebook. Notice the discrepancy in returns for those small growth stocks (aggressive growth) between the years 2002 and 2003, or the difference in returns of large growth stocks from 1999 to 2000. This is volatility that you should not want to be subject to by being too concentrated in one specific area of the market, and I am going to make this argument with a mix of statements and calculations:
The vast majority of investors fail at timing the market constantly and with chasing short-term returns
Not only beating the market when the market does well is important, but losing less than the market when the market is down is just as if not more important
Often times but not always, when 2 or 3 of these categories are doing really well, 1 or 2 categories are not doing so well and vice versa
Example: Recent tax increases concern many investors that the market will see a pullback at some point. This may or may not be a valid argument in the short-term, however, these companies will do their absolute best to push the cost of tax increase to another party, whether it involves conducting more business overseas to deal with lower foreign taxes, outsourcing cheaper labor or more aggressively, or passing cost off to the customer. Regardless, this is just one small and specific example of why we believe allocating roughly 25% of stock investments internationally.
When you simply look at the arithmetic average of returns over a long period of time, volatility has a directly correlated relationship with average annual (or another time period) return. More volatility = more negative affect on the long-term growth of an investment.
Let’s look at an initial investment of $100. If you achieve 0% return in year 1 and 0% return in year 2, it should be obvious what you end with: $100. The average return for these two years on an annual basis is 0%.
Let’s look at the same initial investment of $100. If you achieve 50% return in year 1 and -50% loss in year 2, you might think you end with $100. When in reality, you would actually end with $75, a 25% loss overall. The average annual return in a purely arithmetic sense in this scenario is still 0%.
The same result is seen with -50% loss in year 1 and 50% return in year 2: -25% loss overall… or a $100 investment turning into $75 after 2 years.
Another example: A $100 investment into small growth stocks as a whole at the beginning of 2002 leaves you with only $103.59 after 2 years (3.59% overall return) even though your average return between the 2 years was roughly 9% (-30.26% + 48.54%/2). A $100 investment into the overall bond market at the beginning of 2003 leaves you with just under $109 after 2 years (just under 9% overall return for the 2-year period) even though the average annual return between the 2 years was just over 4%.
Takeaway: When you are looking simply at average mathematical returns, the only thing that volatility does is hurt you, and it is ultra-important to have a strategy that attempts to minimize volatility. If you are an existing client of ours and have questions regarding this concept, please don’t hesitate to contact your advisor. If you are not, hopefully this was a great initial learning piece as a new reader!
THE BENEFITS OF DIVERSIFICATION
May 18, 2021
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