Brent Soloway, ChFC®
When discussing investing, one of the most commonly perplexing concepts is the difference between market volatility and market risk.
Many people use these words interchangeably, which, in my opinion, is a big mistake. Understanding the difference between these two concepts can be the difference between attaining your long-term investment objectives or failing miserably.
Consider these definitions:
- Risk is the probability that an investment will result in permanent or long-lasting loss of value. In simple terms, that money is gone forever.
- Volatility is the rapidity and/or the amount an investment tends to change in price over a period of time.
When establishing a portfolio, I feel it is important to match the goals of the portfolio to the needs of the individual investing the funds. This sounds obvious but, surprisingly, I have found many people do not have a goal for the growth and/or income of their portfolio. Assuming an appropriate allocation of equity and fixed income, and the placement of the money in sound investment vehicles, time will generally average out the short-term iterations of the stock market (volatility).
While there are never guarantees in investing, a well-structured portfolio with sound investments has an excellent chance of meeting expectations over the long haul. There may be violent market moves and periods of negative returns, but a slight tweaking to the allocation may be all that is needed to reach your long-term investment goals.
I have found two things get in the way of a successful investment strategy:
- Acting emotionally: From 2007 until March of 2009, the stock market was in shambles. The major indexes dropped as much as 50%. Does that mean all stocks are risky, and people lost a lot of money? For some, it did. Why? Because they reacted emotionally and sold when stocks were cheap.
Owning good, solid companies provides an opportunity to buy them cheap, when other people are selling. We are talking about companies like Procter and Gamble, Costco, Johnson & Johnson, and many others like these large companies that have been around for many, many years. If you buy more stock during these market downturns, there is a strong possibility that you may achieve excellent returns when the market rights itself. Your purchase price has averaged out when buying the same position at a lower price. This would be an example of volatility (which, arguably, leads to the opportunity to BUY CHEAP).
However, if an investor reacts emotionally and sells, the transaction is complete, the money is lost. The risk cycle is complete if the investor spends the money or never invests the funds again (i.e. keeps it in a savings account earning very little interest). Yes, this investment was risky because the investor did not understand that sound investments are subject to volatility, but over time, history has shown that there is a high probability that the investor may achieve returns he/she was looking for in the first place.
- Liquidating equities in a market downturn to fund a short-term cash need. For many years, I have discussed with clients the importance of monitoring short-term cash flow needs before allocating any money to equities. My definition of short-term is 4-5 years.
For example, you needed $200,000 for a down payment on a home purchase at the end of 2008. It is June of 2006. Your money is invested in stocks and the market is going strong. However, things change, the “Great Recession” and financial crisis hits, and your portfolio is down 40%. You must liquidate at this time to fund the down payment for your home. You have lost 40% on the liquidated assets, because you had to sell to fund a liquidity event (cash needed for the down payment on the home). There is no opportunity to buy more, the positions have been liquidated and used for other purposes.
Now, some smart guy may say that these folks are buying real estate cheap, which may be true, but the point here is that prudent investors understand their cash flow and liquidity needs before exposing funds to market volatility, especially retirees who regularly need income from their investment accounts. That volatility has become risk, because the positions were sold when the values had decreased significantly.
Remember, there are no absolutes when investing. However, if you keep your emotions in check and understand your cash-flow needs, you have gone a long way toward achieving your long-term investment goals. Risk is permanent loss, and volatility is variability over a time frame. When investors understand this, the market undulations, such as we are experiencing now, create investment opportunity.
Any opinions are those of Brent Soloway and not necessarily those of RJFS or Raymond James.