Principle #5: Abhor Risk, Embrace Volatility

Chances are, when you first met with your financial advisor, she asked you to fill out a questionnaire to assess your risk tolerance using a question similar to the following:

“Given your financial goals, how much risk are you willing to assume to achieve your portfolio’s expected return?”

At best, this type of question is misleading. It implies that “risk” is the same as “volatility” (short-term price fluctuations of your portfolio). Given that “risk” is the likelihood  of permanently losing money, the correct answer to the above question is “low” or even “zero”. That is, we have every right to expect not to permanently lose money over our long-term investment horizon of 30+ years (i.e., that we end up with less money than we started).

Further to this point, the above question implies there is a trade-off between risk and reward. While this may be the case in gambling, it’s not typically the case for a long-term investor.

Using risk as a proxy for volatility will likely lead to a poorly designed asset allocation, costing you hundreds of thousands of dollars in the long term. This is because your financial advisor may create an asset allocation that minimizes the fluctuations (volatility) of your portfolio when your intention is to minimize permanent loss (risk). This will be at the expense of average Compounded Annual Growth Rate (CAGR) of your portfolio.

I’ll have more to say in a later post about the impact of CAGR on long-term portfolio value. However, as an illustration, lets’ say you invest $300/month for 30 years and achieve a CAGR of 8%. In this scenario, you’d end up with about $425,000. If we reduce CAGR to 6% (e.g., because we’ve designed a less volatile portfolio), your portfolio would be $294,000 (31% less).

Address the Volatility/Reward Tradeoff

A truly meaningful conversation with your financial advisor should address the following topics.

1. What is your tolerance for portfolio volatility? That is, the likelihood you will sell and permanently lock in your losses should your portfolio decline by (10%, 20%, or more); and
2. A discussion about the trade-off between volatility and reward (long-term rate of return – CAGR).

The above should be put in context with the historical behaviour of the equity market. That is, in any given year, annual market returns have ranged from -42% to +55%  over the past 90 years or so. However, over this same time period, the range of annualized returns (CAGR) for anyone investing over a 30-year time horizon has ranged from 8% to 14% (see this post).

It is only with a through and clear discussion of your tolerance for volatility  that you can truly design a portfolio to suit our long-term goals. You should have zero tolerance for risk (permanent loss).