Think of an image of a car on a bumpy road to an uncertain destination that has already used up its spare tire. The cash reserves of people have been eaten up by the recent market volatility
— Mohamed El Erian, CEO of PIMCO We always hear the word volatility used in the media, by financial advisors and planners like me, but what does it really mean to you as an investor in dollars and cents? Sometimes a picture is worth a thousand words.
Low Volatility High Volatility Plan A Plan B Year Growth of $100,000 Annual Rtn. Growth of $100,000 Annual Rtn. 1 $110,000 10.0% $134,000 34.0% 2 $115,500 5.0% $121,940 -9.0% 3 $131,670 14.0% $153,644 26.0% 4 $143,520 9.0% $129,061 -16.0% 5 $162,178 13.0% $169,070 31.0% 6 $165,421 2.0% $167,380 -1.0% 7 $185,272 12.0% $197,508 18.0% 8 $214,916 16.0% $173,807 -12.0% 9 $227,811 6.0% $210,306 21.0% 10 $257,426 13.0% $227,313 8.0% Average Return 10.0% 10.0% Compound Return 9.9% 8.5% Standard Deviation 4.5% 18.6%
This is a hypothetical illustration and does not represent an actual investment. There is no guarantee similar results can be achieved. If fees had been reflected, the return would have been less. Diversification does not assure a profit or protect against a loss.
This illustration looks at a low volatility vs. a high volatility portfolio.
The average rate of return is the same but the end result show that a lower standard deviation* portfolio can compound at a higher rate of return and create more wealth over time. The longer the time period, the more pronounced the end result can be. Most of the advertising done by investment companies show the average rate of return and may not explain the underlying volatility.
Here is another important point. A portfolio that goes down 50% requires 100% appreciation to get back to even.
In comparison, a portfolio that is down 8% only requires a recovery of about 9% to get back to even.
The greater the loss, the smaller the base on which your earnings can compound.
Yr Growth of $100,000 Annual Return Growth of $100,000 Annual Return 1 $50,000 -50.0% $92,000 -8.0% 2 $54,500 9.0% $100,000 9.0%
You can see from this example it would take years to get back to the original investment.
If you or your spouse is handling your own investments, make sure you both understand the risks you are taking on with your investment strategies.
If you don’t understand, or are unsure how to measure your portfolio’s risk, you may benefit from getting a second opinion or evaluation. The money spent with a professional could save you thousands of dollars in the future. Knowledge is the power and you should understand the “whys” of how each investment made its way into your portfolio and the “how” of how this investment will help you meet your long term investment goals.
*Annual return is the return an investment provides over a period of time, expressed as a time-weighted annual percentage. Sources of returns can include dividends, returns of capital and capital appreciation. The rate of annual return is measured against the initial amount of the investment and represents a geometric mean rather than a simple arithmetic mean. *Average return is the simple mathematical average of a series of returns generated over a period of time. An average return is calculated the same way a simple average is calculated for any set of numbers; the numbers are added together into a single sum, and then the sum is divided by the count of the numbers in the set. *The compound return is the rate of return, usually expressed as a percentage, that represents the cumulative effect that a series of gains or losses have on an original amount of capital over a period of time. Compound returns are usually expressed in annual terms, meaning that the percentage number that is reported represents the annualized rate at which capital has compounded over time. *Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.
“March is one of the particularly dangerous months to speculate in stocks. The others are July, January, September, April, November, October, June, August, December and February.” –Mark Twain
All investments carry some type of risk. Today, I am going to focus on risk as it is measured by standard deviation (SD)*. Go on, keep reading. I hope I can make this an understandable concept!
Let’s use the example of choosing to invest between Product A and Product B. Product A has an expected rate of return* of 4% with an SD of 2%. This means that about 2/3* of the time, this investment is expected to return between 2% and 6% (plus or minus 2%).
Product B has an expected return of 10%, but the expected SD is 20%. This means about 2/3 of the time Product B should return -10% to +30%.
In dollars, a $10,000 investment in Product A would be expected to grow in the range of $10,200 to $10,600 (again 2/3 of the time) over a one year time period. Product B’s return would result in a range from $9,000 (a $1000 loss) to $13,000. Product B has a greater reward potential but also greater loss potential than Product A. It is clear that Product B is “riskier.” Note: 1/3 of the time the gains and losses are even greater.
Another consideration to think about: if you had to liquidate your funds to raise money, you may have to sell your investment for less than your original investment. Understanding this concept is very useful in helping you determine what an appropriate investment would be. The moral of this blog is to make sure you fully understand the risk you are taking before you make an investment. If you have the time and the temperament to take on risk, that is okay. The objective is to have all the facts in order to make the most informed decision. Check out our website www.fishandassciates.com and check on the box, What is your risk score?
In my next blog we will discuss the meaning of volatility.
*Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. *A rate of return is the gain or loss on an investment over a specified period, expressed as a percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security plus realized capital gains. *In statistics, the 68-95-99.7 rule — or three-sigma rule, or empirical rule — states that for a normal distribution, nearly all values lie within 3 standard deviations of the mean. About 68.27% (2/3) of the values lie within 1 standard deviation of the mean. Similarly, about 95.45% of the values lie within 2 standard deviations of the mean. Nearly all (99.73%) of the values lie within 3 standard deviations of the mean.
Do you have a substantial amount in savings, but lack confidence and knowledge when it comes to investing? Do you know how much you need to be saving to be on track to retire someday?
If you are a member of Gen X (those born between 1965 and 1982), or between the ages of 34 and 51, most of you have time to make a plan and create a way to monitor your progress. If you don’t have an end goal in mind, it is difficult to know if you are on track or not. And if you have not started to plan, don’t wait any longer. According to a study by the Transamerica center for retirement studies, 45% of Gen X workers prefer not to think about or concern themselves with retirement investing until they get closer to their retirement date. Don’t stick your head in the sand, start planning today!!
I often see people come into my office that are saving appropriately, but their investment allocation* is much too conservative to have their dollars working to help them grow their income account over time.
Have you heard of the “rule of 72”? It is basic financial concept that illustrates how many years it will take to double your money. Let me give you a Hypothetical example. Let’s say you are 30 years old, you have saved $50,000 and it’s earning 2%. By the time you are 66, the $50,000 would grow to $100,000 (72 divided by 2=36). Let’s assume you invested in a diversified* portfolio (small, medium, large companies around the world and some bonds in a hypothetical portfolio) that we assume you average 7% rate of return. Now, according to the rule of 72, your money doubles about every 10 years. In dollars, you would have accumulated over $500,000 in the same 36 years. This of course is just a hypothetical example. My point is how you diversify your investment may have a huge impact on your future income. It could be the difference of $4,000 per year in retirement vs. $20,000 from the same starting point.
If this makes sense to you but you’re not sure how to apply it to your own personal situation, take the time to meet with an advisor or take a class on investing. Maybe start a group of other like minded friends and do an investment work club and ask an advisor to come in and facilitate to make sure you understand the why’s and how’s of what you’re doing in your 401k and other investments.
* Using allocation and/or diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.
By mid-February of this year, our firm lost four beloved clients to “premature death.” Not one of these clients lived to what we consider “normal” life expectancy, which is 83 to 85 years old, depending on who is providing the numbers. Statistics also show on average, that women outlive men, but that was not the case for us, as 3 of the 4 clients who died were women.
Since we are a financial planning firm, the majority of our clients have an estate plan in place, with wills trusts, healthcare directives, etc, and we stay on the procrastinators to get it done.
I’m addressing this blog to those of you under 40 who think, “I’m young and healthy, or “I don’t have a lot of assets” or “I only have debt” or– I’ll deal with this later.” Here’s something to think about – tragedies happen all of the time, at any age and all ages. Part of growing up and living life on your own terms is to take some important steps today to appropriately deal with your finances. Here is a short list:
1. Create a health care directive. This clearly states your wishes if you were to become comatose. I highly recommend using the five wishes, which describes your wishes for life support as well as who you want to make these decisions, in narrative form. It is free and is legally recognized in 48 states. Call our office at 901-767-0668 and we will send you the form. www.thefiveswishes.com 2. Create a list of all your social media and bank/credit card logins and give it to someone you trust should something happen. 3. Make sure you have beneficiaries on IRA’s and 401Ks. It is free to add a payable on death (POD) or Transfer on Death (TOD) to bank accounts and non-retirement accounts. 4. Consider a small life insurance policy to pay for funeral expenses. 5. If you have specific items to give, assign the items in writing to the person you want to have them. This may seem morbid, but it is not, it is the responsible thing to do. We are all going to die – that is a fact.
I hope this inspires you to go home and have a discussion with your room mate, partner, spouse or parents, or any significant person in your life.
Note: Due to industry regulations on communication, we are unable to allow for public comments on this blog. Please feel free to email me your questions and/or comments to email@example.com. Thank you. Securities and Investment Advisory Services offered through NFP Securities, Inc., Member FINRA/SIPC. NFP Securities, Inc. is not affiliated with Fish & Associates.