Investment volatility is the movement in price of a particular investment. Many consider volatility as prices falling, but volatility is movement in price up and down. Volatility should not only be considered a risk (prices moving down), but also a potential reward (prices moving up).
If a price is stable and does not move, we can consider it to not have any price volatility. Price volatility can obviously vary in magnitude. In investing, volatility should always be measured in absolute terms (how much it moved up and down in percentage terms) and in relative terms (how much it moved up and down relative to another investment).
Think about an investment, that moves 0.0001% on average every day. Then compare that to a similar investment but that price moves 0.0002% on average every day. Although it appears that the investment doesn’t move much in absolute terms, the second investment’s volatility is relatively two times that of the first investment. The difference in volatility is 0.0001% between the two investments. Now think about the dollar impact of this small percentage volatility move in investments. Since the global financial markets trade in trillions of dollars every day, a 0.0001% move in volatility on $1 trillion results in a move of roughly $1,000,000 per day.
Now think about an average investor and their investments. Say there are two investors, one with $5,000 invested and one with $5,000,000 invested. Both invested in the same investment that moves 8% up or down on average each year. The investor with $5,000 will experience swings of $400 up or down each year. The investor with $5,000,000 will experience swings up or down of $400,000 each year. The percentages are the same but the absolute dollar is very different.
Remember, even though the anticipated percentage volatility of the investment has not changed, the dollar volatility does change based on the amount invested. For someone that continues to add money to their investments, one would believe that the dollar amount of volatility would increase over time even if the average percentage volatility does not change. So if your $10,000 account turns to $100,000 over time, and you continue to invest the same way in the same volatility investment you did when you started, you have to remain comfortable having larger swings in your account value if you maintain your investment strategy and allocated to investments with the same anticipated volatility level. It hurts to see your savings move so much, particularly on the downside volatility, but remember, volatility works both ways. Volatility by definition means down and up.
As long as you have done the work, done the planning, understand your personal risk, understand your risk tolerance and understand the anticipated volatility of your investments, then focus on the volatility percentages and not the dollar amount. Remember, someone in the same investment is either gaining or losing much more than you in pure absolute dollar amounts. If you cannot handle the dollar swings in your accounts even with the same investment volatility percentage, you need to reconsider the types of investments that have lower anticipated volatility. That investment you had that averaged 8% volatility may need to be swapped out for a different investment with less than 8% average anticipated volatility. With lower downside volatility potential, you have lower upside volatility potential as well.
Set Expectations for Volatility
One of the best things an investor can do is set their expectations for the volatility of their investments, particularly on the downside volatility. If an investor can have relatively high confidence that they know their investment can fall 8% on average from its high point every year, then they are less likely to become emotionally nervous when it happens. Even better, if an investor can continue to add to their positions every year, the investor can become more excited when the downside volatility occurs. If the investment falls 8% that year, the investor can buy more of that investment at a lower price. That should get investors excited. Then, when the upside volatility occurs (remember, volatility is both down and up) and the investment rallies, the investor could consider selling some of their positions for profit.
For most investments, the average volatility doesn’t always work out for the period under consideration. For example, an 8% average volatility each year, could result in one year with 4% volatility and one year with 12% volatility. The average of those to years is 8% volatility per year. Financial markets often move in extremes, and its the downside volatility that generally results in investors becoming emotional investors and making poor investment decisions. For this reason, rather than just focusing on the average volatility, you want to focus on the anticipated maximum drawdown of that investment.
Maximum drawdown should be considered the deepest price decline in an investment from its peak to trough. In reality, any investment could theoretically go to zero, but the probability of all investments going to zero is low. If you are allocated to an investment that you have high confidence that it will not go to zero and there is a high probability it will appreciate in value or generate income over time, you can attempt to figure out the average maximum drawdown of the investment.
Financial market generally move along with the business cycle and individual investments move along with the broader markets and their own factors. To get a sense of the average maximum drawdown of your investment, you can calculate this number going back in time by seeing how far the investment falls from its peak to trough on average over a 5-10 year period, if available. If you do not have this data readily available, if you know the average volatility of the investment, say 8% each year, triple or quadruple that amount to get a sense of the average maximum drawdown. So in this case, for an investment that has 8% annual volatility, the average maximum drawdown would be somewhere between 24% and 36% (8% x 3 = 24%, 8% x 4 = 32%) and that should occur every 5-10 years.
Most investors care more about the downside volatility but often forget of the anticipated upside volatility. Let’s say there is an investment with 12.5% average annual volatility. Then let’s say there is a recession in the U.S. and the investment falls 50% (using our 12.5% annual volatility x 4 = 50%). This 50% maximum drawdown is within your average maximum drawdown target that you expected and are not freaking out about. Now, since we know volatility moves down and up, and you’ve done the work that your investment should appreciate over time, even with short-term expected volatility. In this scenario, your expectations are that the investment will get back to its highs at some point.
Let’s say you have $100 invested in Investment A that has a price of $100 (so 1 share of Investment A), but just fell 50% down to a price of $50. If you believe the investment will get back to its $100 original price at some point (just based on averages), the current $50 price will get back to $100, resulting in a 100% return on that lower $50 price. So the investment fell 50%, but returned 100% after the selloff just to get back to where it originally was. This concept is not a bad thing and should be taken advantage of.
This author often hears from investment product pushers/marketers about needing to gain 100% on an investment that falls 50%, so they try to sell you their hedged strategies. Sure, you can do that, or you can be patient and take advantage of the significant drops in the markets/investment and add to those positions for significant potential upside.
Maybe you had extra cash, or you had positions that only fell 10% in that market selloff. Say you had another position (Investment B) that also had a price of $100 that only fell to $90 during its own 10% selloff at the same time as your other investment (Investment A) that fell 50% to $50. If you still have conviction in Investment A that fell 50%, consider taking some of the capital from Investment B (a $90 position) and reallocating to Investment A since you are getting it at a much lower price. Let’s say you sold the entire $90 of Investment B and added it to the $50 Investment A position. This results in a full $140 investment in Investment A. Remember, even though Investment A is down a lot, you already expected this average maximum drawdown that occurs every 5-10 years and still believe its a good long-term investment. If you are indeed correct on the long-term prospects of Investment A and the position moves from $50 back to its $100 price, that $140 ($50 + $90) turns into $280.
So during this volatile period, your original investments of $100 in Investment A and $100 in Investment B ($200 total) fell to $140 after the selloff ($100 down in Investment A to $50 and $100 in Investment B down to $90, respectively), you put your full $140 investment in Investment A, Investment A rallies back to its $100 price (a 100% move from $50 back to $100), and now your resulting total investment in Investment A is $280. Then to get back to your original equally split investment mix across Investment A and Investment B, you take that $280 in Investment A, and split it back into equal amounts of $140 in Investment A and $140 in Investment B. So the price of Investment A was flat from point to point ($100 price to $100 price) but with the extreme volatility and taking advantage of buying low in an investment you believed in, you just made $80 and your investments never made new highs.
Anticipate Volatility and Take Advantage
Simple rebalancing strategies in volatile markets (buy during down volatility periods, sell during up volatility periods) can add value over time. The author of the Wisconsin Investor Education website consistently utilizes rebalancing to take advantage of this simple buy low sell high concept for clients.