Clients say “I understand that I need to take on more risk to get the returns I need for my retirement…I have a long time horizon; I’m comfortable with the risk/return factor.” And I’m glad they understand that in order to achieve a higher expected return, they take on more risk – meaning the chance the value in their investment could go up and down.
But even though many clients have thought through their comfort level with risk and return, and take the long-term perspective for their investments, most ignore the importance of reducing the level of volatility in their portfolio as a whole and why they want to do that…and overall volatility has a significant impact on wealth accumulation over time.
Let’s look at two hypothetical portfolios: Portfolio A (low volatility) and Portfolio B (high volatility) with a starting balance of $100,000.
The Impact of Volatility: Source - The Investment Answer, Dan Goldie and Gordon Murray
Both portfolios have an average annual return of 10%, but the low volatility portfolio ends up with more wealth accumulated than the high volatility portfolio. It is really the compound return that matters – when the high volatility portfolio dips down, it requires a greater recovery just to get back to its original value. The greater the loss, the smaller the base on which your earnings can grow!
What should you do? Pay attention to how all the investments in your portfolio track with each other during up and down markets – in general, this is called correlation – you want a mix of assets that are not “highly correlated” with each other. This will help your investments, as a whole, not be as volatile and therefore help you grow your investments.
This data is for informational purposes only; please consult with your advisor or tax professional for your individual situation. Diversification does not ensure a positive return or protect against a loss.