The Error-Proof Portfolio: Risk, Not Volatility, Is the Real Enemy

Note: This article is part of Morningstar.com's November 2014 Risk Management Week special report. An earlier version appeared June 14, 2010.

If you had four options, what would you do if your investments lost 10% in a single day?

a. Add more money to my account.
b. Hold steady with what I've got.
c. Leave my money in, but be beside myself with worry.
d. Yank my money; I wouldn't be able to stand any more losses.

Wait a second--don't answer that. True, such questions are standard fare on risk-assessment questionnaires that you'll find all over the Web, and they have their roots in a well-meaning idea. If investors buy the right investments but sell them at the wrong times because they couldn't handle the price fluctuations, they may have been better off avoiding those investments in the first place.

Unfortunately, many risk questionnaires aren't all that productive. For starters, most investors are poor judges of their own risk tolerance, feeling more risk-resilient when the market is sailing along and becoming more risk-averse after periods of sustained market losses.

Moreover, such questionnaires send the incorrect message that it's OK to inject your own emotion into the investment process, thereby upending what might have been a carefully laid investment plan.

But perhaps most important, focusing on an investor's response to short-term losses inappropriately confuses risk and volatility. Understanding the difference between the two--and focusing on the former and not the latter--is a key way to make sure your reach your financial goals.

What Difference Does It Make?
At first blush, it may seem like the distinction between risk and volatility is purely academic, one that finance eggheads might bicker about but that makes little difference to real-world investors. You certainly see the two terms used almost interchangeably in the investment arena. It's also true that these terms--especially risk--have different meanings for different people.

But as investors, it's helpful to create a mental distinction between volatility and risk. What are the key differences? For starters, volatility encompasses the changes in the price of a security, a portfolio, or a market segment both on the upside (see 2013) and for ill (see 2008). So it's possible to have an investment with a lot of volatility that so far has only gone one way: up.

Even more important, volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period--a day, a month, a year. Such fluctuations are inevitable once you venture beyond certificates of deposit, money market funds, or your passbook savings account. If you're not selling anytime soon, volatility isn't a problem and can even be your friend, enabling you to buy more of a security when it's at a low ebb.

The most intuitive definition of risk, by contrast, is the chance that you won't be able to meet your financial goals and obligations or that you'll have to recalibrate your goals because your investment kitty come up short.

 

Through that lens, risk should be the real worry for investors; volatility, not so much. A real risk? Having to move in with your kids because you don't have enough money to live on your own. Volatility? Noise on the evening news, and maybe a frosty cocktail on the night the market drops 300 points.

However, it's easy to see how the two terms have become conflated. If you have a short time horizon and you're in a volatile investment, what might be merely volatile for another person is downright risky for you. That's because there's a real risk that you could have to sell out and realize a loss when your investment is at a low ebb.

On the flip side, some of the most volatile investments (namely, stocks) may not be all that risky for you if they help you reach your long-term financial goals. And it's possible to completely avoid volatile investments but come up short in the end because your safe investments only generated small returns. You were paying too much attention to the short-term noise, and missed the big kahuna of risks in the process.

How You Can Manage the Two
So how can investors focus on risk while putting volatility in its place? The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you'll be able to harness it for your own benefit. Using a dollar-cost averaging program--buying shares at regular intervals, as in a 401(k) plan--can help ensure that you're buying securities in a variety of market environments, whether it feels good or not.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that's volatile on a stand-alone basis. That can make your portfolio less volatile and easier to live with. For example, core intermediate-term bond funds have a 10-year standard deviation of 3, versus 15 for the S&P 500. Of course, the S&P 500 has posted a much higher return over the past decade, but holding at least some high-quality bonds would have helped take the edge off in 2008, when most stocks lost upwards of 30% while the Barclays Aggregate Bond Index gained 5%.

It also helps to articulate your real risks: your financial goals and the possibility of falling short of them. For most of us, a comfortable retirement is a key goal; the corresponding risk is that we'll come up short and not have enough money to live the lifestyle we'd like to live. For people with kids, paying for college is a goal, but the risk is that you won't save enough and your child will have to turn to alternate sources of financing for school. By identifying goals and risks one by one, you can prioritize them and also troubleshoot what you would do if you fell short of one of your goals.

Focusing on your time horizon for each of those goals can help you arrive at an appropriate stock/bond/cash mix for each. A person just starting out in his or her career, with retirement many years into the future, can handle an equity-heavy portfolio because it helps mitigate shortfall risk. (That's why our Aggressive Saver portfolios--both traditional mutual fund and ETF--feature all or almost all equity funds.) But people closing in on retirement will generally want to hold much more of their portfolios in bonds and cash, because for them encountering a bear market early in retirement could deal their portfolio plans a fatal blow. That's the thinking behind the bucket approach for retirement planning. By carving out a piece of your portfolio that's sacrosanct and not subject to volatility or risk, you can more readily tolerate fluctuations in the long-term component of your portfolio.

See More Articles by Christine Benz