A Practical Primer on Volatility

We hear it all of the time, “the stock market is volatile.”  When we think about it in general terms, the word “volatile” has a negative connotation and can be quite scary.  A Thesaurus gives synonyms for volatile as erratic, unsettled, unstable and fickle.   None of these synonyms are used in the context of what volatility means in the marketplace.

When most of the investment industry talks about stock market volatility, it most often refers to the statistical measurement of standard deviation.  The measurement of standard deviation, or market volatility, makes a number of assumptions based on historical returns.

First, it assumes that the stock market returns are normally distributed.   This is commonly illustrated by the bell curve.  Generally, the distribution occurs from the historical mean of the data points.  Translated, the average return over time is the mean.  Within a normal distribution, 68% of the returns of the stock market will fall within one standard deviation of the mean (average).  So, if the mean is 10% for example, one standard deviation in either direction on the bell curve is 0% and 20%.  In a normal distribution, 68% of those returns should fall within 0% and 20%.  Two standard deviations in a normal distribution should capture 95% of returns, and three standard deviations should capture 99.7% of returns.  That 0.3% of returns that don’t fall within three standard deviations of a return are what some call the “black swan” events that fall outside of the normal distribution.

It’s important to understand that the normal distributions are extrapolated from the mean in both directions.  This means that volatility in the statistical sense happens on the positive and negative side of the average.   For example, since 1926 the standard deviation of the S&P 500 is 18.99 and the mean return is 10.08% through December 2013.  So, in 2013 when the S&P 500 was up 32.41%, that was a volatile year as that return fell outside of one standard deviation (10.08% + 18.99%).  In 2008, when the market fell 37%, that was more than two standard deviations away (10.08% -18.99% -18.99%).  There was no question that 2008 felt more “volatile”, but both 2013 and 2008 were volatile – just in different directions!

While volatility is in both directions, when one has too much of it in a portfolio it could have negative consequences.  First, when it is your life savings and you retire, it can be emotional to see the value of your nest egg bounce around.  For many, the lows are more painful than the highs are joyous.  This often leads to poor decision making as fear and greed overwhelm rational thinking.  This becomes even more of an issue if you are using cash flows from the portfolio to fund your lifestyle in retirement.  For example, if you have $1.00 and you lose $0.50, it takes you 100% return on that remaining $0.50 to get back to that original $1.00.  If you have a $1.00, you lose $0.50 and then spend $0.25, it will take you a 300% return to get back to that dollar.  Volatility and poor timing can mortally wound a portfolio.

What can be done?  Luckily we can use volatility to our advantage!  For example, the mean of the S&P 500 since 1980 is 10.08% and the standard deviation is 18.99.  Those 500 stocks in themselves are a fairly volatile asset class as measured by standard deviation.  However, when you combine multiple asset classes, you can actually reduce volatility without sacrificing the same amount of return.

If we took the following asset data since January of 1980 to December 2013:

We then gave a 25% asset allocation to each of them, and took the returns back to 1980 we would find that the combined allocation would have a volatility (standard deviation) measure of 12.05 and an average annual return of 10.73%.

Compare this to the S&P 500 and you have a diversified portfolio with much lower volatility (12.05 vs. 18.99) and just a slightly lower return (10.73% vs. 11.77%).   While you tradeoff some return, you can lower the volatility significantly with different asset classes.  This is important to all investors, especially ones in distribution stage.

Is this a free lunch?  No, we are sacrificing some return in order to lower volatility and history doesn’t always repeat itself.  However, contrary to popular opinion, volatility should not be feared as a bad thing.  There must be some risk in order to generate return, but carefully combining different types of risks and assets within a portfolio may allow you to lower volatility and generate the return you are looking for commensurate with the risk you are taking.  Using volatility to measure that risk is the first step!

(All data provided by Dimensional Returns software.   Standard deviations are measured from earliest inception date.  Indices are not available for direct investments and performance does not reflect expenses of an actual portfolio.  Past performance is not a guarantee of future results.)

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