The Ocean & Volatility

Submitted by Larry Frank Sr. on Tuesday, March 8, 2016 - 12:00pm
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Nervous retirees often worry that they might lose everything in a volatile market. Yes, if you only own one stock, you could lose it all. But if your portfolio is diversified, the majority of it remains stable like the water beneath the waves.

Market volatility is not as scary as you might think. First of all, younger retirees may have a higher percentage of equity (stocks) in their retirement income portfolio, but as they age, it shallows out. The volatile part of the portfolio from stocks decreases, while the more stable part of the portfolio from bonds increases.

Thus the visual may look like the above picture of the ocean bottom where the blue represents stock index funds and the black represents short-term bond index funds.

Also, not all of one’s portfolio is subject to volatility. Let me explain using ocean waves to represent a portfolio.

The ocean is your properly structured portfolio. In this metaphor, deep water represents younger retirees who have more time remaining before they reach shore.

Take a closer look at the exposure to volatility, the wave action. Looking at just the surface, investors might see a lot of turbulence. Yet below the wave height line, much of the water is undisturbed. The ups and downs of the markets don’t affect most of the portfolio value.

What is the wave height of a portfolio? In other words, how far down may a portfolio value drop? We can calculate the possible loss on a portfolio with its standard deviation, a measurement of historical volatility.

As a statistical rule, future returns fall within one standard deviation 68% of the time, two deviations 95% of the time and three deviations 99.7% of the time. Here is an example:

A portfolio has $100,000 in value (75% short-term bonds, 25% stocks) and a 6.29% standard deviation.

Most of the time (more precisely, 68% of the time), the portfolio likely will go up 6.29%, down 6.29% or any point in between. It means at least $93,710 ($100,000 minus 6.29% of $100,000) of the portfolio is unaffected. And 95% of the time, $87,420 of the portfolio value is intact. The waves might go down three standard deviations, 18.87%; still, $81,130 of the portfolio is fine.

Most of the time, the effect of market storms is shallow, although there are times when they stir deeper, the financial crisis of 2008, for example.

Retirees can survive market volatility because not the entire portfolio is at risk of loss during a down market, that is, if it is properly diversified.

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Larry R. Frank Sr., CFP, is a Registered Investment Adviser (California) in Roseville, Calif. He is the author of the book, Wealth Odyssey. He has an MBA with a finance concentration and B.S. cum laude in physics with which he views the world of money dynamically. He has peer-reviewed research published in the Journal of Financial Planning.

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