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Are Risk and Volatility the Same Thing??

Are Risk and Volatility the Same Thing??

September 15, 2022
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As much as my wife Rachel finds it unusual, I always enjoyed math class. Math came relatively easy to me (unlike foreign language). I was incredibly blessed to have really good math teachers throughout my high school years. Mr. Rosche for Geometry, Ms. Griffith for Algebra II, Mr. Drozin for Probability and Statistics, Mr. Ziegler for Pre-Calculus and Mr. Zimmerman for Trigonometry. 

I am sharing this with you because it occurred to me that a math concept I learned during these formative years known as standard deviation, could help us all become more successful investors.

When looking at investment returns, standard deviation represents the amount of variability both above and below the expected rate of return. The smaller a standard deviation of an investment, the less volatile it is. Conversely, the larger the standard deviation the more those returns can vary. The following chart gives you a visual representation of this.

Source: researchgate.net

Unfortunately, most investors equate volatility with risk. This is especially true when an investment is deviating to the downside. I find it interesting that when volatility breaks to the upside and people get a much greater return than expected from their investment portfolios, it is simply considered good performance (or good fortune). In reality, this is the positive side of standard deviation.

A coin has two sides, so does volatility. You certainly cannot expect a higher overall rate of return without a commensurate variability in those returns. Think about it this way, if you could achieve a higher rate of return, like those you get from common stocks over long periods of time, with a low level of risk, similar to what you would experience with Treasury bills, it would be easy, and everyone would do it. Therefore, everyone would be rich.

We know that the stock market can certainly be volatile over short periods of time. However, over a decades long working life, followed by a retirement that could last 30 years or more, stocks have proven to be a less risky investment than most would think. I will explain.

The S&P 500 closed out 1960 at 58. Even after experiencing a third drop of 20% or more over just the last four years, as I write this in early August, the S&P 500 sits at just over 4100. This means the unmanaged index, widely considered to represent the broad US stock market, has increased by 70X over the last 62 years.

The cash dividend of the same index in 1960 was $1.98. For calendar year 2021 it was a record $60.40. This means cash dividends of the S&P 500 increased 30X. Interestingly, over the same timeframe inflation as measured by the CPI increased approximately 9X.

This does not mean that the returns of the stock market are not volatile. They are. This is evidenced in the chart below.

Since 1980, the stock market has averaged a 14% drawdown annually. Over that same time, the stock market averaged a 13.6% per year positive return. In order to achieve that return, you have to stay invested through the ups and downs of the markets. That’s the price of admission. 

The significant long-term return of stocks can be thought about as watching someone walk up a hill while bouncing a yo-yo. The yo-yo represents the short-term ups and downs of the market, i.e. volatility. The upward slope of the hill represents the market’s long-term returns, and thus the ability to compound your capital for the future.

One of the best questions I ever heard was, “On which side of your investing lifetime will you accept risk, so that you will have less of it on the other side?” You can absolutely invest in CDs and Treasury bills today and have less risk. You are also likely to never achieve the compounded returns necessary to provide for you and your family’s retirement dreams.

Alternatively, you could reframe your views on volatility and risk. Understanding that they are not one and the same will allow you to participate in the historically upward sloping trend of the markets. This will give you a much greater probability of accumulating the wealth needed to provide for you and your heirs. 

I would like to thank my above-mentioned math teachers from Stow High School. They helped me learn valuable lessons that continue to serve me, and therefore hopefully you, well. I thought it was important to remind you of as we continue “Moving Life Forward”. Class dismissed.

The views stated are not necessarily the opinion of Cetera and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.