Last week I enjoyed dinner with a group of people, one of which happened to be a hedge fund manager and fellow CFA charterholder. As us finance-types are wont to do, we quickly made our way to a discussion of every investment nerd’s favorite question: what is risk?
Warren Buffett, in his 2014 Berkshire Hathaway annual letter (page 18), shared his views on the topic:
That lesson [that stocks are less risky than cash-equivalent holdings over the long-term] has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.
Buffett is pointing out that over the long-term stocks are an attractive way to grow capital while cash and their equivalents (i.e., treasury bills) do little more than keep pace with inflation, as can be seen in the chart below. He’s obviously correct on this point, investing in stocks has historically been one of the best things you can do to compound your wealth.
Now then, does this mean people should ignore volatility and only own stocks? I’d say no. Buffett aside, most of us don’t live in the long-term; we live in the present and volatility is a risk that must be managed in the present.
So, despite my better judgment, I’m going to a disagree with one of, if not the greatest investor of all time and my new friend, the hedge fund manager with the NYU law degree and Stanford MBA to his credit—in other words, two very bright people.
Volatility is risk
For nearly everyone, there exist two reasons volatility is a risk to be managed: 1) It can cause investing mistakes, and 2) Most people don’t have an infinite time horizon and are instead using their investments to fund some goal (college, retirement spending, etc.) that exists today.
When it comes to investing, volatility is like speed. The more volatile your portfolio, the more likely you are to make a decision or take some action that’s detrimental to your success—one that causes you permanent harm.
I liken volatility to driving fast. Fast driving alone does no permanent harm to yourself or your vehicle (just like volatility in and of itself doesn’t damage your portfolio—it’s not permanent loss). However, unless you’re a professional race car driver, this behavior seriously elevates your risk of getting in a wreck. Your margin for error decreases and you’ve increased the odds of making a mistake.
So, even if you are young and saving for a retirement date far in the future, you must be aware of the mistakes that volatility can bring. You still need to manage this risk even if you have no plans to touch the money for decades. Just like most of us aren’t professional drivers, most people can’t behave like Warren Buffett. Cambria Investments CIO Meb Faber said:
The reason Buffett is successful is not because he has a magic stock wand, but rather has unbelievable ability to stick to his style.
Most people don’t have the makeup, the discipline and the deep knowledge of market history that gives Buffett his super-human discipline. Most people aren’t going to be able to sit there a watch their portfolio get cut in half, as happens from time to time with stocks. This is why for nearly everyone the right answer, the one that leads to better investments results over time for you, is to manage volatility through a diversified portfolio—oftentimes including cash or it’s equivalents.
Next, most people don’t have the timeframe of Buffett. You can be a long-term investor, sure, but again, the majority of the investing population is using at least some portions of their assets to fund their goals today—whether it’s paying for college or funding spending in retirement. And it’s here where volatility can be really dangerous.
We’ll look at two examples. In both, we assume a $1 million portfolio and a thirty-year time horizon. In the first example, we use the historical risk and return assumptions of the classic 60/40 portfolio—around 8.5% annual returns with an 11.5% standard deviation. In the second example, we invest in stocks only. To drive home the point, we use Emerging Market stocks which have a higher potential for growth but also much higher volatility (roughly 11% returns with 23% volatility).
Despite the over 2% higher annual returns on Emerging Market stocks, we find our 60/40 portfolio has a higher safe withdrawal rate supporting $42,000 in annual withdrawals (68% higher than the Emerging Markets portfolio!) on a $1 million in assets with a 90% confidence level.
Another way to look at this is from a probability of success perspective. If we increase spending to $45,000 annually, the odds of not running out of money over a thirty-year retirement with the 60/40 portfolio is 85%, and this falls to 70% with the all-stock allocation, again, despite the higher returns.
The different types of financial risks to beware of is long: permanent loss, longevity, liquidity, etc. but I’d argue for just about everyone volatility should be included in this list as well. As the team at ReSolve Asset Management has written, “financial risk is singularly defined as the probability of not reaching financial goals”—and, as we just saw, the higher the volatility of your portfolio, the higher the chance that you fail to reach your goals.
Most people have neither the discipline nor the timeframe of Warren Buffett. As a result, most people cannot ignore volatility as a type of risk to manage when building their investment portfolio. On this Buffett is wrong—volatility is risky for you even if it isn’t for him.
*Just so we’re clear, I consider Warren Buffett one of the greatest investors and communicators of all time. This is not meant as a slight against him in anyway; I find myself agreeing with him on most everything he writes about investing. Plus, he’s got 70-some billion reasons not to care what I think. 😉
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