moneyFYI
Financial Freedom Is Merely Organized Common Sense
Volatility?
Trying to talk to most people about volatility and using it as an analog for risk is similar to talking to a 12-year-old about cassette audio tapes. You just get a shrug and a quizzical look.
We know that over long time spans the stock market is quite stable. It has averaged about 10% or a little less and shows little sign of moving from that. On Monday the 21st there will be a more lengthy discussion of this point. If you have not done so already, sign up now (on your right) so you will receive an email of the article.
Averages are general numbers and for volatility, it is the fine detail that matters. What is the range of value that my fund my present me with when I want the money? That can be fairly wide because the stock market does not grow steadily. It is wildly divergent from the average in a given year.
Standard deviation is the marker for volatility and thus for risk. It is a statistical measure and is the amount by which when added or subtracted from the average return will create a range where about 68% of the observed values lie. For the Toronto index, 15% is a decent estimate.
That means if you start with $10,000 in a market with a 10% expected yield at the end of the year you can expect, 68% of the time, to be somewhere between $9,500 and $12,500. Pretty volatile. Thus risky.
What if you don’t care about the one year value? (Trust me it is easier to say you don’t care before you get hit with a down year.) If you use a thirty-year time horizon, long enough to have the volatility mostly cancel out, you will find the standard deviation is about 1.2%. You could rationally expect 9.9% plus or minus 1.2%.
Even that creates a wide spread in end values. If you invest $1,000 per year for 30 years at 9.9% you would have a bit over $175,000. If you hit the low end of the range then $140,000, and at the high end $225,000.
Still a fairly wide range. There are some things you need to do:
- Know your time range. Unless you intend to be broke before you die, it is from now to life expectancy. Probably much longer than 30 years.
- Set target amounts in ranges you can live with. Ranges matter. Absolute numbers are a trap.
- Review regularly and adjust as you go.
You can control volatility for your own purposes by having reasonable expectations, by paying attention to the world around you including your own needs, and by acting on what you discover.
Risk is not necessarily risky. As Warren Buffett says, “Risk is what happens when you don’t know what you are doing.”
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Contact: don@moneyfyi.com | Follow Twitter @DonShaughnessy
Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
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