Volatility is the Friend of Smart Investors

By Dr. Harry Markowitz

AnotherZombie-1.jpg

During a previous crisis I wrote a piece titled “‘The Sky is Falling!’ What should I do?” Basically, the piece advised the investor to stay the course. The argument in brief was summarized in the following paragraph:

Figure 1 shows the level of the S&P 500 since January 1950. At the start of the period, the S&P 500 had a value of just over 17, at the end (on October 9, 2008, as this is written) it had a value of 909, well under its recent high – or its high at the top of the tech bubble – but well aSky is Falling Figure 1bove 17.

The only thing that has changed since October 9, 2008 is that it is now August 11, 2011. As of last night’s close the S&P 500 was at 1120, well below its recent highs but well above 909, not to mention its value of 17 in 1950. The advice offered in the previous piece (which depended on the investor’s choice of GuidedChoice risk class) is still applicable. You can read the original piece here.

At this point the reader may be willing to concede that, on average over the long run, the stock market is a good investment. But now the reader may be worried about the volatility of the market between now and the appropriate “long run”. My response to this worry depends on how far away is the time for which the reader is saving.

First, suppose that this time, e.g., the reader’s retirement date, is a long way off. The market will no doubt fluctuate between now and then, but will most likely be a lot higher then than its current level. In this case market volatility is actually beneficial. GuidedChoice rebalances each portfolio every quarter. That means that if the stock market goes up substantially during the quarter, so that the portfolio’s equity level is substantially higher than the reader’s target level, GuidedChoice will sell stocks from the portfolio and put the proceeds into bonds or cash. Conversely, if the stock market falls substantially GuidedChoice will buy stocks, reducing the fraction of the reader’s portfolio in cash or bonds. Thus GuidedChoice buys low and sells high for the reader. Technically, this is called “volatility capture” and is clearly a good thing for on-going portfolios.

Next, suppose that the retirement time is close at hand. Then market volatility is worrisome because it threatens the amount that will be available to retire on. The reader may want to reduce his or her risk class as the retirement time approaches. Note, I say “may want to reduce his or her risk class.” This decision depends on a number of factors. First, with any luck the reader is not going to die at retirement time; he or she is going to live another twenty or thirty years, or perhaps longer. If he or she puts almost all his or her wealth into bonds or cash the real value of the reader’s portfolio – adjusted for inflation – is likely to shrink unfortunately fast as the years go on. Other considerations which should be taken into account in deciding the reader’s portfolio risk level as retirement approaches includes the reader’s wealth level – specifically, whether the reader’s current wealth level well above that which is necessary to support the reader’s customary standard of living – and, how burdensome would it be for the reader to retire a couple of years later if the market took a bad bounce.

The problem of what risk level should be adopted as the reader approaches retirement, and into retirement, is complex. Rather than offer some simple-minded, mechanical “target date” solution to this problem, GuidedChoice offers a new product – GuidedSpending – which guides the reader’s choice of risk level, annuitization level and consumption rate as a function of current and subsequent market performance. Read more about GuidedSpending.