The accepted wisdom is risk is volatility
That is one way to think about it, but volatility by itself is not risky. What is risky is how much will the investment be worth on the day in the future when you want to sell it.
While volatility can be calculated to many decimal places, when and why you need the money is mostly unknown. So, maybe volatility is not as crucial as we think.
If you trade a lot, volatility matters
Volatility is the annualized standard deviation of returns. It makes sense if returns are distributed normally, bell curve, but they are not quite. Market returns tend to be taller and skinnier than a bell curve, are not quite perfectly symmetrical, and they have bumps at the extremes where bell curves are near zero. We can assume that that doesn’t matte, but assumptions come with risk.
We know that the longer term volatility is quite small compared to very short term results. There is a formula to approximate how it changes. Take the time of the short duration and the time of the long duration. Let say daily versus one year. There are roughly 250 trading days in the year so the annual and the standard deviation is roughly the daily times the square root of 250.
Suppose daily volatility is 1.1%, then annual will be 1.1% times 15.81 equals 17.4%. In terms of volatility we are not much the wiser. The key element is the ratio of volatility to yield.
The daily return space roughly. 04% plus or minus 1%. It is about 50 times as wide as the daily yield. Mostly noise.
Annually the ratio 10.5% yield and 17.4% volatility. Much more capable signal. If the market results were normally distributed we would expect this year to fall in the space yield plus or minus volatility roughly two thirds of the time. So -7% to plus 27%. A space roughly three times bigger than yield.
Volatility is a drag on yield if you turn the portfolio over too quickly.
That’s why we care about the holding period. For long term investors the ratio of the yield to the space gets lower as you hold securities longer. More predictable in simple terms.
When you trade frequently, you get taken in by the volatility and on average your yield will fall by about half of the square of the annual standard deviation. In the stock market that could cost about 1% annually so yield 9.5% instead of 10.5%
Trading daily is anti-statistical
With a yield of .04% and standard deviation of 1% you should expect on average to be around -.45%. Yikes.
There is another cost.
Emotionally losses hurt us more than gains of the same size bring us joy. Trading frequently increases the exposure to negative results and so we felt worse than we should. The market needs to be up twice as many days as it is down to feel good. Historically, the 10%+ yield happens with only a tiny bias towards the plus side.
You could earn reasonable yields and be upset all the time.
Keep it simple.
Sound sleep is inversely proportional to perceived risk. The thing you know without the math – sell until you sleep.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.
In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772