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May 16, 2015

Downside Volatility vs. Long-term Wealth

Wall Street defines risk as volatility. The more a fund or portfolio fluctuates in value, the riskier it is deemed. The vast majority of individual investors define risk differently. Individual investors, in aggregate, define risk as the chance of losing money.
Both definitions are correct. If time horizons are very long or infinite, then the degree to which a fund or a portfolio fluctuates does not matter as long as the expected gain is large enough. This viewpoint works very well for developing mathematical equations. Whenever expected returns and volatility can be specified, a quantitative model can be constructed to determine whether it is logical to expect an investor to be compensated for the amount of risk taken. The Sharpe ratio is an example of this type of model.
Human emotions are far different than the logic underlying mathematical models. We view losses and gains differently, as Nobel laureate Daniel Kahneman and Amos Tversky documented. Specifically, they found that people will not act in their economic best interest in order to avoid a sure loss. This is because we humans feel greater pain from losses than pleasure from gains.
If mathematical models treat gains and losses equally, but humans derive more pain from losses than pleasure from gains, then a disconnect clearly exists. Some academics and practitioners have tried to resolve the difference by creating of various measures to assess risk.
One of them is the “Pain to Gain” ratio. Recently on the Financial Planning website, Craig Israelsen explained this formula. It divides the standard deviation of return by the actual return. The standard deviation, in this case, is the amount an asset’s return deviates from its typical range of returns. You can calculate it by downloading return data from a website such as Yahoo Finance and using the “STDEV” function in Microsoft Excel. In describing the indicator, Israelsen wrote, “We want to experience less volatility (pain) for a given level of return (gain)—so the lower an investment’s score, the better.” (Israelsen used rolling 10-year period returns in his article, but told me in an email that 36-month periods can also be used. The more common practice for calculating risk measures is to use monthly returns for the past 36 months.)
At AAII, we use a similar but slightly different measure: the risk index. This is the standard deviation of a fund’s or portfolio’s return divided by the standard deviation of return for a benchmark. The benchmark can be a broad market index (e.g., the Dow Jones U.S. index) or a fund’s category average. A score of 1.0 indicates greater risk than the index and values below 1.0 indicate lower risk. This measures tell you whether or not a portfolio (or a fund) has incurred greater price volatility than its benchmark.
Knowing how relatively volatile a portfolio (and/or a fund) is can help you adjust your investment strategy to allow you to sleep better at night. But volatility works in both directions. What matters to most investors is how much downside volatility there is. One measure of downside volatility is the Ulcer Index, a more complex mathematical equation that considers the retracement in value (or price). A simpler rule of thumb is to compare monthly drawdowns between a portfolio or a fund and an appropriate benchmark. Another rule of thumb would be to calculate the risk index for up and down months; this would reveal whether the excess volatility is incurring on the upside (a good thing) or on the downside (which could fray your nerves).
The big thing to remember is that you have to be willing to accept downside volatility if you want to build long-term wealth. A savings account will ensure your wealth never drops in absolute terms (as long as you don’t make withdrawals), but you will lose out to long-term inflation (prices will rise at a faster pace than your savings will grow at). A portfolio composed entirely of stocks will give you the largest amount of growth over the long term, but your net worth may rise and fall significantly over the shorter term. In between are a wide range of allocation options, each with varying degrees of risk and reward. Finding a mix that keeps the pain of downward market moves at a tolerable (not comfortable, but tolerable) level can help you achieve your long-term goals.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle
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