From the July 2015 issue of Investment Advisor • Subscribe!

Volatility: Why It Matters and What You Should Do About It

The markets have been calm for some time, but volatility will return

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Volatility can take a bite out of clients' portfolios. Volatility can take a bite out of clients' portfolios.

Summer is upon us and many investors will be turning their attention away from the markets for a few weeks to enjoy some time off. It seems as good a time as any to allow oneself to be distracted from financial affairs because despite the fact that there is plenty to worry about (and there always is), U.S. equity markets have been remarkably calm lately.

Volatility is low and could remain so for a while, as the summer months tend to be more placid. Consider that the standard deviation of returns for the Russell 3000 Index over the year ending on May 30 was about 9.3%. Since the index's inception in 1979, its one-year rolling volatility has only been lower than its current level about 20% of the time. Additionally, if we look at the S&P 500 over the same time period, we can see that there have been only two trading days out of 252 with moves of 2% or greater, and both of those moves were to the upside.

However, when volatility rears its ugly head again—and that's inevitable—it will be too late to batten down the hatches. Protection from adverse market events needs to be in place prior to volatility spikes in order to be effective.

Before investors decide to reduce volatility in their portfolios, they have to believe that volatility is something to be avoided. We’ve heard market pundits say that volatility isn't risk because risk is the permanent loss of capital, but the fact is that the higher the volatility of an asset, the greater the uncertainty around its value when you need to sell it.

Volatility is problematic for two reasons. First, there is the psychology of losing money. Even professional investors are susceptible to making ill-timed decisions in the face of losses. Investors who bail when times get tough typically reinvest too late into a recovery.

Volatility and Compounding (Source: 361 Capital)

The other reason volatility is problematic? Its effect on compounding. Two assets with the same average return will have different compound returns if their volatilities differ. In the table above, you’ll see that both investments have an average return of 10% over the five-year period, but Investment A, which has no volatility, compounds at 10%, while Investment B, which has a standard deviation of 16.9%, compounds at 8.9%. Compounding can have a huge impact on the investment's end result, potentially adding years until one is able to retire.

While we can't correct for our behavioral faults and we can't change the mathematics of compounding, we can mitigate the damage that volatility can cause. Advisors might want to take advantage of the current lull to equip their clients’ portfolios for the next bout of volatility.

There are myriad ways to brace for higher volatility. Strategies include buying options or Treasuries, or adding to cash, but each of those approaches requires effective timing.

Alternatively, allocating away from long-only equity strategies in favor of a long-short combo offers greater risk management with the potential for greater alpha generation. It's worth noting that long-short equity strategies lost about 20% on average during the financial crisis, which, while painful, was a far cry from the losses of 50% or more experienced by many equity indexes.

Over a lifetime of investing, volatility will make a significant difference in your clients’ net worth, so taking the time to prepare for it now is well worth the effort.

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